INDONESIA: CRITICAL CONSTRAINTS TO INFRASTRUCTURE DEVELOPMENT

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3 INDONESIA: CRITICAL CONSTRAINTS TO INFRASTRUCTURE DEVELOPMENT Zafar Iqbal and Areef Suleman ECONOMIC RESEARCH AND POLICY DEPARTMENT Rajab 1431H (July 2010)

4 For enquiries about this publication, please write to: Director, Economic Research and Policy Department, Islamic Development Bank, P.O.Box 5925, Jeddah 21432, Saudi Arabia Fax: Rajab 1431H (July 2010) DISCLAIMER The views expressed in this paper are those of the authors and do not necessarily represent the views of the Islamic Development Bank Group or its Executive Directors or its member countries. Islamic Development Bank Economic Research and Policy Department ISBN

5 FOREWORD In the Mid-Term Development Plan , the Government of Indonesia has prioritized infrastructure development with the goal of improving the competitiveness of the economy. Needless to say that adequate and quality infrastructure is crucial for achieving sustainable and inclusive growth, which will ensure shared prosperity for the whole country. Given the magnitude of infrastructure investment requirements, the government needs both domestic and foreign partners. In this regard, the PPP Book 2010 offers potential investment opportunities that could be exploited by the private sector. This highlights a new paradigm for the provision of infrastructure where the role of government is of an enabler than a developer in the sector. The government is also committed to accelerating infrastructure projects through PPPs by adopting a proactive approach. To that end, many reforms have already been implemented and a number of laws enacted to ensure a more streamlined approach for private investors. In particular, the current Presidential Regulation 13/2010 aims to effectively resolve the problem of land acquisition the binding constraint to infrastructure development. The Regulation specifically stipulates that central, provincial and/or local government must first acquire land prior to soliciting bids for infrastructure projects. The government is confident that under the improved business conditions, PPPs in infrastructure will flourish. The government has implemented several important policy reforms over the past few decades. As a result, today the country has strong macroeconomic fundamentals and political stability. The government also aims to further connect various regions to achieve balanced socio-economic development, particularly by providing adequate access to infrastructure in order to expand employment opportunities and improve the living standards of people. This is the first Infrastructure Diagnostic Study for Indonesia and forms part of an overall Growth Diagnostic for the country. The overall diagnostic study was jointly conducted by the Asian Development Bank (ADB), the Islamic Development Bank (IDB) and the International Labor Organization (ILO) in close coordination and cooperation with Bappenas. The government acknowledges the key contribution of the IDB in undertaking the study. The in-depth analysis of key sub-sectors of infrastructure (i.e., transport, electricity, and telecommunications) and the process-oriented plan for relaxing the binding constraints are of immense value to the government. The consultative nature of the Study has ensured that the views of key stakeholders involved in infrastructure development in the country have been properly accommodated. The government is committed to addressing the most binding constraints as identified in this study, such as to resolve the problem of land acquisition; improve human and institutional capacity; improve governance; and facilitate long-term financing. The Study is, thus, very timely and will be a valuable source of input for the government s mid-term infrastructure plan, which will be implemented over the next five years. The government believes that the findings and recommendations of the Study can form part of the basis for engaging development partners in its quest for high levels of sustainable and inclusive growth in Indonesia. The GOI will response quickly and accurately to avoid, and even eliminate the constraints, so that Indonesia s Infrastructure development would have its momentum as supported by various financial institutions. I appreciate IDB s efforts and its desire to be involved in Indonesia s Infrastructure Development. Finally, I expect the cooperation between the IDB and the GOI will provide benefits for both sides and especially for the prosperity of the entire Indonesian people. Lukita Dinarsyah Tuwo Vice Minister of National Development Planning/ Vice Chairman of National Development Planning Agency Republic of Indonesia

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7 PREFACE Indonesia: Critical Constraints to Infrastructure Development is the first diagnostic study the Islamic Development Bank (IDB) has conducted in Indonesia, an important member country of the Bank. The study has been carried out in collaboration with the Asian Development Bank (ADB) and International Labour Organisation (ILO) aimed at diagnosing the present state of the Indonesian economy. This report focuses specifically on the constraints to infrastructure development in Indonesia. Although Indonesia s overall economic performance improved over the past five years ( ) it is still below the levels achieved prior to the Asian crisis. One of the underlying reasons for the sluggish growth is the lower levels of investment in the infrastructure sector. This insufficient investment resulted in the inadequate supply of infrastructure services (both in terms of quantity and quality). Hence, it is not surprising to see that the Government of Indonesia has acknowledged the inadequacy of infrastructure as a major hindrance to achieving inclusive growth in the country. The report identifies the most binding constraints to infrastructure investment. At the same time, the study concludes that relaxing those constraints will facilitate investment by removing the impediments that has thwarted economic growth and development in Indonesia. Zafar Iqbal and Areef Suleman, the two authors who have conducted the study, are from the Bank s Economic Research and Policy Department. The study was based on extensive consultations with key stakeholders from both the public and private sectors throughout the process, beginning with the development of the diagnostic framework. The identification of the binding constraints to infrastructure development was determined via a primary stakeholder survey. These results were then validated by an in-depth sub-sectoral analysis. The results were discussed with the Government of Indonesia and the key stakeholders. A sequential, processoriented approach is proposed to relax the binding constraints for infrastructure development. Ifzal Ali Chief Economist Islamic Development Bank

8 ACKNOWLEDGEMENTS The authors are thankful to Ifzal Ali, who initiated the study and provided valuable guidance, comments and suggestions from the beginning to the successful completion of the report. Abdullateef Bello and Nosratollah Nafar provided the necessary support. Ehsan Khan of ADB provided constructive comments in finalizing the report. Background materials related to infrastructure sector were provided by Abuzar Asra and Irman Boyle. Data support by Rehan Kausar of ADB is also acknowledged. The IDB Field Representative in Indonesia, Makhlani, was instrumental in obtaining necessary data and providing insight into key issues relating to the country. Nina Permatasari provided valuable logistics and administrative support. The authors are also grateful to Abdul Rashid, Mohamed Amza and Musharraf Wali Khan for secretarial and administrative assistance. Chovakran P. Saleem coordinated the production of the report. We are also grateful for the support provided by the Government of Indonesia. In particular, we would like to thank Ir. Lukita Dinarsyah Tuwo, Vice Minister National Development Planning; Dedy Priatna, Deputy Minister for Infrastructure Affairs; Ir. Bambang Prihartono, Director, Directorate of Transportation; Budy Hidayat, Director for Settlements and Housing; and Maurin Sitorus from the Ministry of Finance.

9 CONTENTS EXECUTIVE SUMMARY... ix I. INTRODUCTION...1 i) Background...1 ii) Why Focus on Infrastructure...2 iii) Contribution to Indonesia s Economic Growth...2 iv) Quality of Overall Infrastructure...3 v) Infrastructure Business Environment...4 vi) Regional Infrastructure Imbalances...6 II. III. IV. FRAMEWORK FOR DIAGNOSING CRITICAL CONSTRAINTS TO INFRASTRUCTURE DEVELOPMENT...9 i) Infrastructure Diagnostic Framework...9 ii) Hypotheses...11 KEY ISSUES TO INFRASTRUCTURE DEVELOPMENT...12 KEY FACTORS AFFECTING INFRASTRUCTURE INVESTMENT IN INDONESIA...16 i) Factors Constraining Infrastructure Development...18 ii) Impact of Scarcity, High Cost, and Poor Quality on Infrastructure-related Business...21 iii) Slow Improvement in Overall Business and Investment Climate for Infrastructure-related Business Over the Last Three Years...21 iv) Major Binding Constraints to Infrastructure Development...23 V. SUB-SECTORAL ANALYSIS...23 i) Transport...27 ii) Ports...38 iii) Railways...45 iv) Airports...49 v) Electricity...53 vi) Telecommunications...65 vii

10 VI. CONSOLIDATION OF SURVEY RESULTS AND SUB-SECTORAL IN-DEPTH ANALYSIS...73 VII. UNDERLYING REASONS FOR KEY CONSTRAINTS IDENTIFIED...76 i) Difficulty in Land Acquisition...76 ii) Weak Human and Institutional Capacity...80 iii) Poor Governance...84 iv) Shortage of Financing...86 VIII. PROCESS-ORIENTED PLAN FOR RELAXING THE BINDING CONSTRAINTS: CROSS SECTORAL...87 i) Resolving Difficulties in Land Acquisition...87 ii) Strengthening Human and Institutional Capacity...90 iii) Improving Governance...93 iv) Improving Availability of Financing...95 v) Sector-specific Interventions...96 IX. ANNEXURES...99 Annexure A: Key Institutions, Policies, and Rules and Regulations in Infrastructure Development in Indonesia Annexure B: Road Transport Annexure C: Ports Annexure D: Railways Annexure E: Air Transport Annexure F: Electricity Annexure G: Telecommunications REFERENCES viii

11 EXECUTIVE SUMMARY In this era of globalization and international competitiveness, sustainable socioeconomic development and poverty reduction cannot be achieved without adequate and efficient infrastructure. Indonesia s reliance on expanding better quality infrastructure is, therefore, understandable, given the country s geographic spread, waterways and land mass. Empirical studies have shown the positive correlation between infrastructure and economic growth. And one study estimates that a 1 percent increase in infrastructure investment could contribute 0.3 percent to Indonesia s gross domestic product. However, the current state of infrastructure is far from encouraging, and it came as no surprise when the business community identified its inadequacy (in terms of both quantity and quality) as the second biggest impediment to doing business (after inefficient government bureaucracy) in Indonesia. This inadequacy is directly attributed to the relatively lower level of investment in the sector. The situation has gotten worse since the Asian financial crisis in the late 1990s. It is, therefore, not surprising that the country lags behind its regional competitors (specifically Malaysia, Thailand and Vietnam) on various infrastructure indicators. The other factor that may have contributed to the lower level of investment in infrastructure development is a dilemma faced by the government over whether it should allocate more resources toward reducing the high level of disparities between different regions in terms of per capita GDP, population density, infrastructure and investment flows. However, reducing regional disparities should not be considered as a short-term priority. Given limited resources (financial, physical, human and institutional), addressing regional disparities and the binding constraints to economic growth simultaneously may lead to a state of paralysis, with no progress on either of these issues. Hence, it would be prudent to focus on economic growth in the short-term (by relaxing the binding constraints) and on regional disparities in the long-term. The Government of Indonesia (GOI) has come up with an ambitious mediumterm plan to relax the infrastructure constraints that are thwarting economic growth. According to tentative estimates, approximately $143 billion (Rp 1,429 trillion) is required for the purpose over the next four years ( ). However, GOI s track record on implementing capital expenditure budgets raises question about its capacity due to weaknesses at both the human and institutional levels. This constraint, coupled with limited financial resources (the central government can only finance 40 percent of the infrastructure ix

12 required between 2010 and 2014), may have prompted the government to seek other means for implementing its infrastructure investment plan. Not surprisingly, the private sector is increasingly considered as a key to delivering the required infrastructure, either by implementing projects entirely on its own, or via Public-Private Partnerships (PPP). However, unlike many countries in the world, where the private sector is an important player in infrastructure provision, it plays a minor role in Indonesia (the share of private sector investment in infrastructure is less than 1 percent of GDP). For nearly a decade, the rates of infrastructure investment declined from approximately 8 percent of GDP in 1997 to around 3.5 percent in 2006, and it still remains lower than the required level of between 7 percent and 9 percent of GDP. To determine the underlying reasons for this progressive decline, this study has developed an infrastructure diagnostic framework, which provides a consistent approach for identifying the most binding constraints to infrastructure development in Indonesia. The framework starts with a set of proximate determinants of infrastructure development; it investigates which of these are the most binding constraints to infrastructure development, and figures out specific distortions behind the critical constraints. The diagnostic framework focuses on the root causes of the weak state of infrastructure aimed at developing a process-oriented plan for relaxing the binding constraints, thereby facilitating the efficient utilisation of scarce financial and physical resources. On the basis of a primary survey, four major constraints are indentified. They are: (i) difficulty in land acquisition; (ii) weak institutional and human capacity, (iii) poor governance; and (iv) shortage of long-term financing. The survey findings are validated by an in-depth analysis of three major infrastructure sub-sectors: (i) Transport (roads, railways, ports and airports); (ii) Electricity; and (iii) Communications. On the basis of the survey results and the in-depth analysis, the two most binding constraints to infrastructure development have been identified: (a) difficulty in land acquisition; and (b) weak institutional and human capacity within the government. Similar constraints also plague the Indonesia-Malaysia-Thailand Growth Triangle (IMT-GT) Initiative launched in1993, which resulted in its slow progress, especially with regard to strengthening roads, railways, airports, ports and electricity infrastructure at the inter- and intra regional levels. As part of a future review on the IMT-GT, it is important to understand the underlying factors responsible for the slow progress of flagship projects. This should precede the next phase/ Roadmap of IMG-GT Initiative, and would be best achieved by a detailed diagnostic study encompassing all three countries. x

13 Unless such an exercise is carried out to identify the binding constraints, and develop a strategy to relax the most binding ones and implement it, progress on the IMT-GT Road map will not be forthcoming to the detriment of both growth and equity. Further analysis highlights that from the private sector perspective, the most binding constraint to investment in infrastructure is the difficulty in land acquisition. Due to private ownership of land and the onus resting on the investor to resolve the issue of compensation with the landowners, the problem of determining an equitable price becomes a stumbling block for infrastructure development. In several instances, where land is required for infrastructure projects, landowners inflate prices, and resolution of such matters could delay projects by over three years. In particular, the land acquisition problem is more pronounced in roads and electricity projects, where land requirements are higher. The problem is further compounded by inefficiencies in spatial planning at the regional/provincial government levels, where provincial rules and regulations in determining areas for infrastructure development have not been finalized yet. The second most binding constraint is the limited human and institutional capacity within the public sector, which manifests itself in the poor quality of bankable projects. It is also apparent in the government s performance on budget disbursement. Up to 8 September 2009, only 40 percent of the investment budget under the Ministry of Public Works was disbursed. The problem is further compounded with the delay of transferring funds allocated to regional governments. This explains why the government must obtain the required skills to design, budget, and implement the relevant projects. In order for the private sector to participate in infrastructure development, the risk adjusted rate of return needs to be at par with peers in South-East Asia (specifically Malaysia, Thailand and Vietnam). Currently, the low return is attributed to the social tariff-setting in some sub-sectors, and the concerns over land acquisition. Hence, without addressing the skills and capacity issue within the government, and the risk-adjusted returns on investment, it will be extremely difficult to catalyse PPP. Poor governance compounds the adverse impact of the lack of institutional and human capacity. Based on discussions with the private sector, it is apparent that it has factored in the cost of rent-seeking into their project planning and financing costs, and view this as part of their normal business running cost. This rent-seeking activity adversely impacts on project viability, and in some instances, it affects the project quality. Ultimately, the costs of such activities are borne by the end-user. According to World Bank estimates, corruption can xi

14 add up to 20 percent to the cost of doing business in Indonesia, resulting in a high-cost economy and low incentives for investment in infrastructure. The other key constraint is the shortage of long-term financing required by the private sector for infrastructure projects. Discussions with local commercial banks revealed that they are only willing to provide financing for a period of up to seven years, while state-owned banks may go up to 12 years. Infrastructure projects by their very nature require financing in excess of 12 years. Commercial banks cannot satisfy this requirement due largely to the mismatch between the time-horizon for their sources of funding (short-term) and financing requirements for infrastructure projects (medium- to long-term). It is worth noting that currently, 90 percent of local banks finance comes from savings accounts, demand and time deposits, and only 1 percent from longterm bonds. The funding structure is, therefore, inadequate to fund long-term investments. In this context, it is important that banks diversify their funding sources to include more longer-term financing, either by issuing global bonds or through long-term borrowing from international banks. In addition to the four binding constraints described above, additional constraints unique to some of the infrastructure sub-sectors are identified. These include: In road, the issue of lack of bankable projects in the toll roads warrants specific mention since GOI has, on several occasions, tried to involve the private sector in projects that have high social returns, but lack appropriate financial returns on investment. In this context, GOI should take a conscious decision to focus solely on those projects that yield high social returns, while creating a climate conducive for private sector participation in those projects that have higher financial returns on either a Build-Operate-Transfer or Rehabilitate-Operate-Transfer basis. For seaports, weak institutional and human capacity within the government manifests itself in its inability to prepare bankable projects, which results in a perception of low returns on investment. The regulatory framework hinders competition in the ports sector, adversely impacting efficiencies. This has increased rent-seeking opportunities and encouraged monopolistic behavior. The lack of natural deep-water harbors and a river system prone to siltation are also of concern as it requires expensive and time-consuming dredging to ensure adequate port depth. New investment in air transport infrastructure is also hampered by perceived low returns on investment. Given the vastness of the country, it is not surprising that there are a good number of airports, but many xii

15 of them are not financially viable (albeit exhibiting high social returns on investment). Even at the local government level, there is reluctance to accept responsibility for these airports due to the adverse effect on budgets. In this context, the central government should explore possibilities of appointing private companies to operate these airports on its behalf. Instead of getting many small-scale operators to run various airports, economies of scale may make these airports more attractive if a few large-scale operators are offered a basket of investment opportunities. Investment in electricity infrastructure is also hindered by social tariffsetting below cost recovery. The pricing policy for electricity supplied by Independent Power Producers (IPPs) is below cost of supply in some instances (particularly in remote areas with low load factors) and the lack of an appropriate risk-sharing mechanism with IPPs. Currently, the bulk of the risk lies with the private sector, which is unable or unwilling to carry such risk. An effective risk sharing mechanism should be developed based on the principles that risk be allocated to the party that is in the best position to address and mitigate it. The government would be ideally suited to manage risks related to the country, political, and/or government actions/events, while the distributor (the stateowned company-perusahaan Negara/PLN) should carry risks related to electricity network operation (including demand/supply, and grid failure). Private investors and lenders, on the other hand, must bear risks related to construction, operation, and maintenance of IPPs. The monopolistic environment and anti-competitive behavior in telecommunications has discouraged new investment in the sector. In addition, its business environment is clouded by the lack of transparency and discriminatory practices on inter-operator charges (there are allegations that charges to the state-owned subsidiary are lower than those of other cellular operators). Although the sector-specific constraints highlighted above warrant attention, they should be addressed by the line ministries, and not divert national attention away from the binding constraints hampering investment in infrastructure. In order to address the abovementioned constraints in a manner that has maximum impact, it is critical that the constraints are relaxed in a sequential nature. Relaxing the binding constraints increases the risk-adjusted rates of return and encourages new investment. In addition, the constraints are not independent of each other, and by addressing the bindings constraints, other bottlenecks are simultaneously addressed. Although, the analysis provides a snapshot of the constraints at this point in time, this is neither a one-off xiii

16 process, nor is it static. Once those constraints are relaxed (over the next months), such diagnostic analysis should be repeated to identify the binding constraints and develop measures, policies and programs to overcome them in the future. To address the most binding constraint of land acquisition, the government established a revolving fund of approximately $60 million (Rp 600 billion) along with the recent promulgation of regulations that limit the legal options available to property owners to challenge the government efforts to acquire land for infrastructure projects. This was supplemented by a further $120 million (Rp 1.2 trillion) budget allocation for financing the gap between estimated and actual land prices. Nonetheless, it is important for the government to take the responsibility for land acquisition, and for the investors to focus on the actual project execution. In addition, the government may have to embark on rapid resolution of land disputes either via the judiciary or non-populist land expropriation legislation that is implemented in an effective and humane manner. Without such mechanisms, quick and effective resolution of land acquisition may remain elusive. The development of human and institutional capacity is at the core of any future growth and development of the Indonesian economy. It is apparent from the study that several constraints relate to this fundamental issue. Unfortunately, there are no quick fixes to the problem. In the short-term, some of the functions (e.g., project identification and preparation of prefeasibility studies) may need to be outsourced. Development partners can play an important role in capacity building by developing and funding skills and knowledge transfer programs. They should focus on process-oriented and soft skills, and developing the ability of relevant officials to understand how to use the newly-acquired knowledge and skills to addresses the key constraints in infrastructure investment. As part of the development programs, both intra- and inter-institutional capacity will need to be developed in order to get government institutions to work together in a complementary manner. Hence, legal and regulatory changes may need to be implemented to enhance capacities of government institutions and their agencies at all levels. Although the study identified several constraints, the two most binding remain the difficulty in land acquisition and weak institutional and human capacity. This study suggests a process-oriented plan with a short-term (12-24 months) and medium-term (24-60 months) approach. The short-term measures proposed for consideration by the government to ease the two most binding constraints are: xiv

17 i) Increasing the efficiency of the judiciary. A strict moratorium on land sale, once it has been designated for infrastructure, must be enforced. In addition, the GOI will have to undertake an international benchmarking exercise to study best-practices elsewhere in the world, and use these experiences to develop appropriate mechanisms, policies and legislation to expedite land acquisition. ii) Preparation of pre-feasibility studies. The costs of undertaking such studies would typically amount to 1-2 percent of total project costs. Based on government s medium-term planned expenditure of approximately $143 billion, the cost of preparing pre-feasibility studies for the infrastructure projects would range between $1.5 billion and $3 billion. iii) Development of a Management Information System (MIS) for infrastructure projects. This system should be developed by an international firm with the relevant experience and would form the basis for government coordination meetings where bottlenecks can be identified, discussed and resolved. In order for the MIS to be effective, it has to be fully integrated with a monitoring and evaluation (M&E) system that would be utilized for following up on the various projects. Although the focus is on infrastructure, there is no reason why the MIS and M&E systems could not be implemented across governments to provide real-time information on project status. The intention is to get these critical areas up and running as quickly as possible, while ensuring skills transfer and capacity-building components remain an integral part of them. More importantly, there must be a clear exit strategy and performance agreement for the consultants. In addition, the government will have to embark on a capacity-building exercise for staff involved in infrastructure development. Although the costs appear high, they must be measured against the cost of not getting projects on the ground quickly enough, and the levels of confidence they would instil in the potential projects tabled by the government. An independent credible assessment may result in several projects being reclassified as potentially viable for publicprivate partnerships, or deemed appropriate to seek private investors. This could reduce the financial burden on the government and assist in getting more projects rapidly into the implementation and operational stages. Furthermore, in implementing the short- and medium-term process-oriented plan, Multilateral Development Banks could play the catalytic role to ensure win-win outcomes that will jumpstart inclusive growth in Indonesia. The issue of long-term financing will require serious efforts by the government. However, by addressing the priority areas of land acquisition and inadequate xv

18 human and institutional capacity, the major risks relating to returns on investment and project implementation can be mitigated, and in this manner, access to capital (both local and foreign) will be easier. Overall, the analysis provides valuable insights into the factors constraining infrastructure investment by the public and private sectors and PPPs. The identification and prioritization of the binding constraints are important in both the design of policies and specific initiatives. At the same time, prompt relaxation of those constraints will facilitate faster economic growth, and improve both the business and investment climate and the quality of life in the country. xvi

19 I. INTRODUCTION Infrastructure projects are identified by the President of Indonesia Susilo Bambang Yudhoyono as one of his major priorities over the next five years in efforts to boost growth and reduce poverty. i) Background The Islamic Development Bank (IDB), in partnership with the Asian Development Bank (ADB) and the International Labour Organisation (ILO), embarked on a country diagnostic study for Indonesia based on the growth diagnostics framework originally developed by Hausmann, Rodrik, and Velasco (2005) 1. The study provides an analysis of the constraints hampering sustainable and inclusive growth in Indonesia. These constraints are explored in greater detail with a view to determining the most binding constraints. In order to relax these constraints, they are prioritized, and then remedial measures are suggested with a view to providing guidance to Indonesian policy makers, development planners, and donors in formulating Indonesia-specific growth strategy. The study examines critical constraints in three areas: i) economic growth; ii) poverty reduction and inequality; and iii) employment. In the area of economic growth, weak infrastructure was identified as the most critical bottleneck. This aspect of the study has been undertaken by the IDB. The slow pace of infrastructure development and its poor quality are attributable to the low level of investment by both the public and private sectors in Indonesia. The low-level of public investment may be due to limited financial resources and weak institutional and human capacity, which adversely affect the government s ability to identify, design, and implement suitable infrastructure projects. Private investment, on the other hand, could be hampered by low appropriatibility (related to weak governance and corruption), decentralization of infrastructure development, resulting in additional rent-seeking activities, non-availability of long-term financing, and land acquisition problems. Public-Private Partnerships, which have been viable elsewhere in the world to overcome government s limited financial capacity, have been unsuccessful in Indonesia due largely to government failures in developing appropriate bankable projects, weak legal and regulatory framework, and a lack of information on infrastructure projects. It must be noted that these factors may merely be symptoms, masking the underlying causes. In order to identify the 1 Hausmann, R., D. Rodrik and A. Velasco, 2005, Growth Diagnostics, John F. Kennedy School of Government, Harvard University. 1

20 root causes, the problems hampering infrastructure development need to be examined in greater depth. ii) Why Focus on Infrastructure Over the past five years ( ), the overall economic performance of Indonesia has improved, with an average growth of 5.5 percent. This achievement was consistent with improvements in the efficiency recorded by both the government and private sector. However, when compared to the average annual growth of 7.8 percent between 1988 and 1997, the economy is clearly not performing to its potential. One of the underlying reasons for this low level of growth is the lower levels of investment in infrastructure of around 3.5 percent of GDP in 2006, compared to the pre-crisis level of approximately 8 percent in The infrastructure sector has been acknowledged by the Government of Indonesia as a key component of the economy, given its large land mass, remoteness, and untapped trade potential. The importance of increased investment in new infrastructure along with the maintenance and rehabilitation of existing ones is widely recognized by stakeholders. Inadequate supply of infrastructure services (both in terms of quantity and quality) is viewed as the second biggest obstacle to achieving inclusive growth in Indonesia after inefficient government bureaucracy, with policy instability rated as number 3 2. Not surprisingly, the business community in general, and the investors in particular, have identified transport, electricity, and telecommunications as the main constraints to doing business in Indonesia. Available information also indicates that access to infrastructure services varies widely across provinces. The focus on infrastructure is warranted due to: (i) its contribution to economic growth; (ii) the relative weakness of its quality; (iii) it being identified as one of the key obstacles to doing business in Indonesia; and (iv) the regional imbalance in access to infrastructure. These elements are discussed in greater detail in the following sub-sections. iii) Contribution to Indonesia s Economic Growth Several studies have examined the relationship between infrastructure and economic growth in Indonesia. For example, Mawardi (2004) shows that infrastructure positively impacted on Indonesia s economic growth. This finding was supported by Yudhoyono (2004) and CIDES (2007), with a recent empirical study by Mustajab (2009) estimating that a 1 percent 2 World Economic Forum, Global Competitiveness Report,

21 increase in infrastructure investment contributes 0.3 percent to Indonesia s gross domestic product 3. This supports the contention that adequate and good quality infrastructure is a major driver for sustainable economic growth and poverty reduction in Indonesia 4. The importance of infrastructure in Indonesia s economic development is widely recognized. In the early 1970s and 1980s, improvement of irrigation infrastructure in rural areas and roads were given high priority. This resulted in, among others, the substantial rise in agriculture production, leading to selfsufficiency in rice, the country s main staple, in mid-1980s. At the same time, the unprecedented annual growth rate of around 7 percent in the 1980s led to a strong demand for infrastructure development, especially in Java and Bali. In order to sustain and meet the demands of a growing economy, the government needs to accelerate investment in the sector. In this context, the government adopted six fundamental strategies under its Development for All program in One of which is local economic development in every region 5. This strategy includes reinforcement of interregional linkages and enhancement of the quality and quantity of infrastructure. In order to address the constraint of poor infrastructure and its adverse impact on economic growth, the country s mid-term development plan has taken up adequate measures. Based on the importance of infrastructure in Indonesia s growth, it is important to briefly examine its quality. iv) Quality of Overall Infrastructure According to the World Economic Forum Report (2010), Indonesia s overall infrastructure quality is ranked 96 th (out of 133 countries studied), while Malaysia is ranked 27 th and Thailand 41 st. However, Indonesia performed marginally better than the Philippines (98 th ) and Vietnam (111 th ) (Figure 1). This is a cause for concern because the state of infrastructure is inextricably linked to global competitiveness of a country (i.e., better quality infrastructure facilitates higher levels of competitiveness). It is, therefore, not surprising that Indonesia s poor infrastructure quality has negatively impacted on its global competitiveness ranking. According to the World Economic Forum Report (2010), its ranking is 54, compared to Malaysia (24) and Thailand (36). However, it is more competitive than the Philippines and Vietnam. 3 Mustajab (January 2009), Ph.D Thesis on Infrastructure Investment in Indonesia. 4 See Section 2. 5 Address of the President of the Republic of Indonesia before the Special Plenary Session of the House of Regional Representatives, on 19 August 2009, Jakarta. 3

22 120 Figure 1: Rankings of Quality of Overall Infrastructure and Global Competitiveness, (out of 133 countries) Indonesia Malaysia Thailand Philippines Vietnam Ranking of Quality of overall infrastructure Ranking of Global Competitiveness Source: World Economic Forum, Global Competitiveness Report, Note: Ranking out of 133 countries: the lower the ranking, the better the infrastructure quality and better the global competitiveness v) Infrastructure Business Environment Adequate and efficient infrastructure is not only an essential driver for economic growth, it is also critical for ensuring better investment climate and effective functioning of the economy. In Indonesia, investment in the sector is facing various levels of risks. For example, BMI (2010) reported limits of potential returns due to poor infrastructure market and country structure in Indonesia and neighboring countries (Table 1). The higher the score in terms of infrastructure market and country structure, the better the country is. In terms of infrastructure market, Indonesia s score is 50, indicating that the country is better compared to Malaysia, Thailand, and the Philippines. However, in terms of country structure, Indonesia with a score of 45.9 is far below those countries, implying that investors do not see high potential returns on infrastructure investment. With regard to risks to realization of returns, the lower the score, the better the country is. Indonesia, with a score of 41.8 for both market and country risks (i.e., inefficient bureaucracy, political risk, and higher corruption level), is more risky, compared to its neighbors. Combining all the risk factors, Indonesia scores 46.5, which is lower than Vietnam (53.2), Malaysia (49.9), and Thailand (47.8), indicating that overall infrastructure business environment in the country is relatively poor but better than Philippines (42.2). Deep structural problems in Indonesia such as poor governance, political risks, a weak regulatory framework, and opaque tendering process further push down the country s overall infrastructure 4

23 business environment ratings. For instance, according to World Bank estimates, corruption can add up to 20 percent to the cost of doing business in Indonesia 6. Table 1: Overall Infrastructure Business Environment Ratings Limits of Potential Returns * Infrastructure Market Country Structure Overall Limits Risks to Realization of Returns ** Market Risks Country Risks Overall Risks Overall Infrastructure Business Environment Ratings Indonesia Malaysia Thailand Philippines Vietnam Source: Business Monitor International Ltd. (Q1 2010) Indonesia Infrastructure Report * : The higher the score in terms of infrastructure market and country structure, the better the country is. ** : With regard to risks to realization of returns, the lower the score, the better the country is. Given the low ranking of Indonesia s infrastructure quality, it is not surprising that at the national level, inadequate supply of infrastructure is identified as the second most problematic factor for doing business (Figure 2) Figure 2: Most Problematic Factors for Doing Business in Indonesia, (% of respondents according to their rankings) Inefficient government bureaucracy Inadequate supply of infrastructure Policy instability Corruption Access to financing Restrictive labor regulations Tax regulations Inflation Source: World Economic Forum, Global Competitiveness Report, Foreign currency regulations Inadequately educated workforce Poor work ethic in national labor force Government instability/coups Tax rates Poor public health Crime and theft 6 These estimates are reported in Business Monitor International Ltd., Indonesia Infrastructure Report Q

24 In neighboring Malaysia and Thailand, businessmen and investors consider inadequacy of infrastructure as the 10 th most problematic factor. In terms of adequacy of infrastructure, Indonesia slid from its 53 rd ranking in 2008 to 55 th in 2009 (out of 57 countries), significantly behind Malaysia (26 th ) and Thailand (42 nd ), but slightly ahead of the Philippines 7. The findings of a 2008 survey conducted by Japan External Trade Organization (JETRO) revealed that 28.4 percent of the respondent Japanese firms with active or planned investments outside Japan considered inadequacies in infrastructure was a major constraint to investment in Indonesia. Of concern is that this represents an increase of 4.5 percentage points over the 2007 levels. These findings are an important gauge of the potential foreign investors perceptions of the attractiveness of investing in Indonesia, as those who have not yet invested there are greater options to locate elsewhere than those who have already invested in the country. At the regional level, the problem is more acute because of the huge disparities in resources and economic activity described below. vi) Regional Infrastructure Imbalances Given the vastness of the country and its limited financial resources, it is not surprising that there are regional imbalances in terms of availability and access to infrastructure. For instance, in addition to the low teledensity of fixed-line telephones, there are large disparities within the country, ranging from the highest teledensity in Greater Jakarta (about 25), medium densities in other big cities (11-20), and to the lowest in rural areas in Eastern Indonesia (approximately 0.2) 8. Households with access to safe drinking water also indicate significant variations across provinces. In 2007, close to 66 percent of households in Sumatera and 87 percent in Java had access to safe drinking water, while in Kalimantan only around 50 percent of households enjoyed that facility 9. Access to infrastructure and productive assets is also low and unequal across regions. Electricity users, in terms of percentage of families, ranged from 37 percent to 73 percent and access to asphalt/concrete road, in terms of percentage of villages, varied from 40 percent to 72 percent. The above imbalance is due mainly to low investment in infrastructure in regions outside Java and Sumatera. In 2008, Java received 91.2 percent of 7 IMD World Competitiveness Yearbook (2009). International Institute of Management Development, World Competitiveness Yearbook (2009) measures the adequacy of infrastructure in terms of the extent to which basic, technological, scientific, health and environment, and education infrastructure meet the needs of businessmen and investors. 8 Village Potency BPS Susenas Kor

25 realized FDI and 60.1 percent of domestic investment. On the other hand, Sumatera got 6.8 percent of FDI and 23.8 percent of domestic investment (Table 2) 10. This is not surprising since returns on investment will be higher where populations are denser. Under the mid-term plan ( ), the government intends to allocate more public investment in regions that are clearly unattractive to the private sector. The regional imbalances will need to be carefully assessed in order to maximize the impact of government expenditure, while avoiding a situation where laggard regions may feel marginalized in the process of development. Provinces Table 2: Realized FDI and Domestic Direct Investment and Gross Regional Product by Regions (percent of Total) Realized FDI Realized Domestic Direct Investment Percent share in GDP Sumatera Java Bali and Nusa Tenggara Kalimantan Sulawesi Maluku Papua Total For FDI and Domestic Investment, website: For Gross Regional Product, OECD Economic Survey, Indonesia Economic Assessment (July 2008) On the basis of the above, it is clear that development of adequate infrastructure is vital not only for the country s economic growth but also for improving the quality of its people s lives. However, both the quality and quantity of Indonesia s infrastructure along with the regional imbalances leave much to be desired if the country is to achieve higher levels of inclusive and sustainable growth. Given the limited human and institutional capacity in Indonesia, government efforts would have a greater impact on economic growth and development if it remained focused on relaxing the most binding constraints to infrastructure (Box 1). This study focused on the inadequacy and the poor state of infrastructure in Indonesia and how it has affected the country s overall development. Section II presents the framework developed in this study. Section III provides a perspective on what are the binding constraints to infrastructure development in Indonesia.This is followed by a more in-depth analysis of key sub-sectors

26 Box 1: Reducing regional disparities should become a long-term priority There are high levels of disparities between the different regions in Indonesia from several perspectives. For instance, GDP per capita ranges from Rp2.4 million in Gorantalo to Rp36.7 million in Jakarta; population density varies from only 5 persons per km2 in Papua to 13,560 persons per km2 in Jakarta. In addition, the regional disparities are also evident in terms of the extent of investment flows and infrastructure at the regional level. % Share sin Total Investment and GDP Regional Disparities in Terms of Investment, Output and Population, DKI Jakarta Jawa Timur Jawa Barat Jawa Tengah Riau Sumatera Utara Kalimantan Timur Banten Sumatera Selatan Kalimantan Barat Kepulauan Riau Sulawesi Selatan Papua Kalimantan Tengah Sumatera Barat Nanggroe Aceh Lampung DI Yogyakarta Bali Nusa Tenggara Barat Sulawesi Utara Kalimantan Selatan Sulawesi Tengah Jambi Sulawesi Tenggara Papua Barat Kepulauan Bangka Nusa Tenggara Timur Gorontalo Bengkulu Sulawesi Barat Maluku Utara Maluku % Share sin Total Population % Share in Total GFCF % Share in Total GDP % Share in Total Population The disparities are attributable to low levels of investment in the different regions, which is driven by a decision-making process based on the financial and social returns on the investment. An example would be in the provision of electricity where cost of services vary between approximately Rp1000 per Kw to Rp4000 per Kw in the different regions (since prices are fixed and uniform across the country, serving a few people in sparsely populated areas results in high losses). Therefore, in terms of infrastructure (transport, communications and electricity), it is not surprising that the more densely populated areas tend to have more infrastructure, which is also of a higher quality. Given the limited human and institutional capacity within government, and the overall business and investment climate, there are tradeoffs for redressing regional imbalances. In the short-term, by focusing on relaxing the identified binding constraints, government will create a conducive environment for higher levels of investment, the country onto a higher growth trajectory, thereby improving the living standards of a vast majority of the population. If, however, government decides to focus on addressing regional disparities in the short-term, it runs the risk of not being able to make an impact on both disparities and economic growth (since it has limited human and institutional capacity and would not be in a position to address the binding constraints). As such, government should weigh the opportunity costs of embarking on a populist decision of reducing regional disparities as opposed to pursuing economic growth. Unfortunately, given limited resources (financial, physical. human and institutional capacity), within government, it should not take on more than it has the capacity to deliver. Confronting regional disparities and the binding constraints to economic growth simultaneously may lead to a state of paralysis, with no progress on either of these issues. Hence, it would be prudent to focus on economic growth in the short-term (by relaxing the binding constraints) and on regional disparities in the long-term. 8

27 in Section IV followed by Section V, wherein the key conclusions of the study are presented. II. FRAMEWORK FOR DIAGNOSING CRITICAL CONSTRAINTS TO INFRASTRUCTURE DEVELOPMENT Using the growth diagnostic approach developed by Hausmann, Rodrik, and Velasco (2005), a diagnostic framework for the infrastructure sector has been developed (Figure 3). The additionality to the Hausmann, Rodrik and Velasco approach is the inclusion of the role of all stakeholders (public and private sector, public-private partnership, and foreign investors) in infrastructure development, as opposed to purely focusing on private investment. The framework provides a consistent approach to identifying the most binding constraints to infrastructure development. The approach offers a practical tool for policy makers to use in formulating a strategy for the sector. It may also assist the international donor community toward providing funding aimed at removing the binding constraints faced by the various sub-sectors, thereby maximizing their developmental impact on the country. i) Infrastructure Diagnostic Framework The diagnostic framework starts with a set of proximate determinants of infrastructure development; it investigates which of these are the most binding constraints to infrastructure development; and determines specific distortions underlying these constraints. The framework addresses the root causes of the weak state of infrastructure, which leads to a policy agenda that is focused on relaxing the binding constraints. This approach is well-focused compared to the laundry-list approach of the Washington Consensus, which attempts to remove all distortions simultaneously. Critical constraints to infrastructure development in Indonesia are attributed to three broad factors: (i) low-level public investment; (ii) low-level private investment; and (iii) weak public-private partnerships. In order to determine the underlying causes for low levels of investment in each of these categories, the issues and drivers behind them are examined. Low-level of Public Investment in Infrastructure: The diagnosis starts by examining why the level of public investment in the sector is low. Is this due to budgetary constraint, or limited implementation capacity? Is it low due to corruption or poor governance? Weak Public-Private Partnerships: The diagnosis explores what are the main factors limiting public-private partnerships (PPPs) in infrastructure. Are PPPs weak due to shortage of bankable projects or insufficient regulatory framework? 9

28 Low Level of Public Investment Budgetary Constraint Leakages Tight Fiscal Position Corruption High Borrowing Costs Poor Governance Other Development Priorities Limited Implementation Capacity Weak Institutions Lack of Huamn Capital Figure 3: Critical Constraints to Infrastructure Development Weak Public-Private Partnership (PPP) Low Level of Private Investment (including FDI) Government Failures Market Failures Low Return on Infrastructure Investment High Cost of Finance Shortage of Bankable Projects Lack of Access to Financing Low Social Returns Low Appropriability Bad International Finance Shortage of Local Finance Lack of Institutions Distorted Price Structure Poor Geography (Natural Disasters) Government Failures Market Failures Low Private Savings Lack of Incentives Lack of Information Low Human Capital Land Acquisition Problem Information Externalities Poor Intermediation Weak Regulatory Framework Micro Risks (High Cost of Doing Business) Coordination Externalities Low Quality and Inadequate Infrastructure Macro Risks (Financial, Monetary, and Fiscal Instability) Restriction on Foreign Ownership 10

29 Low-level of Private Investment in Infrastructure: The diagnostic framework looks into what is hampering the level of private investment in the sector. Is it low because of micro risks (i.e., high cost of doing business) or macro risks (i.e., financial, monetary and fiscal instability)? The obstacles to infrastructure development are verified in greater detail using the latest available data and information. This allows determination of the binding constraints within each category, and facilitates the development of specific solutions to each sub-sector. Based on the diagnostic framework, the following hypotheses have been developed and tested/ validated. ii) Hypotheses Low-level of Public Investment in Infrastructure 1. Government has limited capacity from both institutional and human capital perspectives. This has adversely impacted on its ability to identify and implement suitable infrastructure projects. 2. The ability of the government to increase public investment in new infrastructure along with the maintenance and rehabilitation of existing infrastructure is constrained by limited financial resources. Low Level of Private Investment in Infrastructure 3. Private investment in infrastructure, particularly in roads, toll roads, and electricity, is constrained by land acquisition problems. 4. Low level of private investment is due largely to poor governance and corruption. The problem is exacerbated by the decentralization of power, which has resulted in additional rent-seeking activities, albeit at higher levels. 5. Non-availability of long-term financing is a constraining factor for private investment in infrastructure projects, which generally take a long time to complete. 6. Micro risks, specifically around the cost of doing business, coupled with weak institutional and human capacity result in poorly prepared bankable infrastructure projects, making it difficult to attract private investors to the sector. Weak Public-Private Partnerships 7. Weak public-private partnership is due to shortage of bankable projects, lack of institutional capacity, weak regulatory framework, or provision of low quality and inadequate infrastructure. 11

30 III. KEY ISSUES TO INFRASTRUCTURE DEVELOPMENT Following the above framework, three broad factors hampering infrastructure development in Indonesia have been identified. They are: low levels of both public and private investment and weak public-private partnerships. The following sub-sections examine the underlying constraints affecting public and private investment, and public-private partnerships in the country. Low level of Domestic and Foreign Investment The poor quality and inadequacy of appropriate infrastructure is closely related to low level of investment. Since the Asian crisis, Indonesia was unable to provide adequate funding in infrastructure development. After the crisis, investment in the sector declined significantly-- from approximately 8 percent of GDP in 1997 to slightly above 2 percent in 2000, rising gradually to around 3.5 percent in Although the situation has improved since 2000, it is still far below its pre-crisis levels. It is important to note that in 2005, infrastructure investment in Indonesia (around 3 percent of GDP) was lower than in Malaysia, Thailand and Vietnam (over 7 percent of GDP), although comparable with that in the Philippines 11. Investment from both private and public sectors has declined, but the fall in private investment has been more drastic, dropping to below 1 percent of GDP from 2 percent in the mid-1990s (Figure 4). Private investment is 9.0 Figure 4: Infrastructure Investment in Indonesia, (percent of GDP) Private SOE Sub-National Govt. National Govt. Source: Data provided by Asian Development Bank, Jakarta, Indonesia 11 World Bank Connecting Asia: A New Framework for Policy and Action. 12

31 concentrated in power, telecommunications, electricity and transport (mainly toll roads). This low level of investment must be viewed in the context of the government s mid-term plan ( ), wherein Indonesia will require infrastructure investment of at least 5 percent of GDP 12, and World Bank estimates of required investment between 7 percent and 9 percent of GDP 13. In absolute numbers, under the mid-term plan, it is estimated that Rp. 1,0924 trillion will be required for investment in infrastructure. The GOI has clearly expressed its inability to fund the country s infrastructure requirements, and is seeking to leverage funds from the private sector (domestic and foreign) along with mobilizing resources from its development partners. Foreign direct investment (FDI) is an important source of financing the infrastructure sector. Like domestic private investment, FDI flows are recovering slowly in recent years but remain lower than its pre-crisis level. The existing data indicates that there is a huge gap between approved and realized foreign direct investment, particularly in In 2003, the gap was around $10 billion, which rose to nearly $30 billion by It is worth noting that close to one-third of the FDI in 2007 went to transport, storage and communication (Table 3). The rising gap between approved and realized FDI is a cause for concern for the investment community and its impact on the country s business environment. Table 3: Approved and Realized Foreign Direct Investment in Indonesia, / Approved FDI (US$ million) 16,305 10,471 13,640 15,665 40,146 of which: Electricity, Gas & Water Supply (percent of Total) Construction (percent of Total) Transport, Storage & Communication (percent of Total) Realized FDI (US$ million) 5,445 4,572 8,911 5,992 10,341 of which: Electricity, Gas & Water Supply (percent of Total) Construction (percent of Total) Transport, Storage & Communication (percent of Total) Gap Between Realized and Approved FDI (US$ million) -10,860-5,899-4,729-9,673-29,805 Source: Indonesia, Offering Memorandum (April 2009), and BKPM. 1/ Excludes FDI in oil and natural gas projects, banking, non-bank financial institutions, insurance, leasing, mining, portfolio as well as household investment. 12 Bappenas. Mid-Term Plan ( ). 13 World Bank and IFC (June 2009). 13

32 Figure 5: Funding Requirement for Mid-term Infrastructure Plan in Indonesia, (Rp billion) Source: BAPPENAS, 2010 Weakening Public-Private Partnerships The level of private participation in infrastructure projects declined from about $7.5 billion in 1996 to less than $1 billion in It remained low between 2001 and 2005 (ranging from $1billion to $2 billion per year), but started to grow from 2005, reaching approximately $5 billion in However, it was still lower than the 1996 level (Figure 4). Cumulatively, between 1990 and 2007, the private sector participated in 86 infrastructure projects valued at over $40 billion, mainly in electricity, telecommunications, and roads. Medium-term Infrastructure Investment Plan According to tentative estimates, in its medium-term infrastructure plan for , the government has estimated the country s infrastructure financing requirement to be Rp 1,429 trillion, with an average annual growth of more than 12 percent in order to support its economic growth of 5-7 percent per annum. The government is targeting to increase the share of infrastructure investment to 5 percent of GDP (Figure 5). During the next five years, it would promote improvement in investment climate involving the private sector. The government also plans to initiate various reforms to attract domestic and foreign investors to invest in the sector. In this regard, it has published a PPP Book, which contains plans for the infrastructure projects that would be offered to the private sector. In the PPP Book, 100 projects with a total cost of $47.3 billion have been identified, mostly in toll roads, water supply, railways and power Bappenas Public Private Partnership Book (2009). 14

33 Figure 6: Infrastructure Investment Requirement in Indonesia, PPP 25% Central Government 47% Local Governments 28% Source: BAPPENAS, 2010 In the medium-term plan, the central government s capacity to finance is only 47 percent while the remaining gap will be covered by local governments (28 percent) and PPP (25 percent) (Figure 6) 15. Despite concerted efforts by the government 16, public-private investment in infrastructure has not been forthcoming to the desired extent. It is, therefore, important that the underlying causes hampering the participation of the private sector in infrastructure be analysed. In addition, there is a need to ensure that potential projects are appropriately packaged so that they become more attractive to private sector participation. In order to accomplish this, the capacity of relevant institutions in implementing public-private partnership 15 Stated by the Minister for National Development Plan Agency, Pak. Dedy Priatna, 17 December For instance, from an institutional perspective, in addition to the existing agencies dealing with infrastructure, in 2005 the government revitalized the National Committee for the Acceleration of Infrastructure Provision (KKPPI) to better integrate efforts to cope with the increasing demand for infrastructure. A number of supporting units such as Risk Management Unit and Government Investment Agency under the Ministry of Finance were established along with a number of PPP Nodes, Center for Government-Private Coordination and Public Service Board. A number of activities to encourage private investment in infrastructure, such as 2005 Infrastructure Summit, and 2006 Infrastructure Forum, were also initiated. In 2006, the government launched an Invesment Policy Package aiming to boost institutional capacity and coordination among line ministries dealing with infrastructure development and regulations. The 2008 Budget Law also indicated government s increased support for infrastructure development. 15

34 8,000 Figure Figure 7: Public-Private 7: Infrastructure Projects, ($ million) million) 7,000 6,000 5,000 4,000 3,000 2,000 1, Source: projects will need to be strengthened in such areas as preparation and marketing of bankable projects to attract long-term domestic and foreign funds (Figure 7). On the basis of the above, it is apparent that levels of investment are far below the requirements of building a vibrant and competitive economy. It is, therefore, appropriate to try to gain a deeper understanding of the underlying causes behind the lower investment levels. To do so, it is necessary to undertake an analysis of the key infrastructure sub-sectors. IV. KEY FACTORS AFFECTING INFRASTRUCTURE INVESTMENT IN INDONESIA In order to determine the underlying reasons for inadequate investment in the infrastructure sector, the IDB undertook a primary survey of selected stakeholders active in the sector between November and December 2009 in Java district in Indonesia. To have a better comprehension of the various questions, a pilot survey, using face-to-face discussions, was carried out in Java District. On the basis of the pilot, the questionnaire was refined and sent to major companies representing the public and private sectors, public-private partnership, and financial institutions involved in the infrastructure development. The total sample size for the survey was 55 key stakeholders (including the pilot phase). Respondents were selected based on their involvement in the sector, especially 16

35 in areas of transportation, communication, electricity, water and sanitation and institutions actively involved in infrastructure projects. The main objective of the survey was to gain first-hand knowledge of the underlying reasons inhibiting infrastructure investment in the country. In particular, the main focus of the survey was on factors related to government failures. This decision was taken based on previous discussions first in the inception workshop (August 2009) and later in consultation workshop (November 2009) of the stakeholders of the public and private sectors held in Jakarta. Out of the potential 55 respondents, responses were received from 30 individuals from both the public (8 responses) and private (22 responses) sectors, representing 55 percent response rate, which is reasonable from a statistical point of view. The questionnaire comprised of six sections, and the major concerns of key stakeholders in the infrastructure sector. The first five sections address issues related to labor; capital; land and environment; government and the cost of doing business. Section VI seeks to ascertain the conditions in the business and investment climate and the progress made by the government during the last three years. Most of the questions were related to availability/access of resources; cost and quality of available resources; and their impact on infrastructure-related activities in the country. All these factors are interrelated. All the questions are specified under the following categories. Availability/Access: The focus of this question was on the availability/ access of a specific factor, purely from a quantitative perspective. For example, short-term funds/ financing may be widely available (i.e., there is no scarcity/ shortage of funds), but the reality might be that the cost of accessing financing or the conditions associated with such funds are prohibitive. Hence in this context, the respondents would highlight that short-term financing is available despite the issue of cost. Cost: Under this category, the focus is purely on the cost of the variables being analysed. The respondents were asked about their perception on the cost of the available resources including land, labor, and capital in total cost of production. Quality: Quality is indicative of the level of satisfaction that respondents exhibit toward a certain issue/variable. Although quality and cost tend to go hand in hand, for this question of quality, cost is not taken into consideration. For example, with regard to services / service delivery, the focus is entirely on the level of service received as opposed to 17

36 whether it is of an acceptable standard given the cost thereof. Impact on business: On this question, the impact is not purely related to return on investment, but rather on the effect of various factors, such as productivity, legal framework and ease of doing business on the overall business and investment climate. Each response provides a focused / narrow perspective on the element under consideration. If looked at in isolation, there is the potential that one may end up with results that focus on treating the symptoms as opposed to the root cause of the problem due to the partial insight obtained from the analysis. However, to be able to gain a more holistic perspective on the matter, we have to look at responses to all categories (this is covered in greater detail under subsection viii): Major Binding Constraints to Infrastructure Development ). i) Factors Constraining Infrastructure Development Based on the analysis of survey, findings of the factors related to availability, cost, quality and their impact on infrastructure-related business are described below. Scarcity In terms of availability/access, (1) lack of coordination within government; (2) poor quality of bankable projects; and (3) weak implementation capacity of the government were highlighted as key constraining factors to infrastructure development. The survey results show that between 48 percent and 62 percent of respondents reported these factors as scarce (Figure 8). In particular, 62 Figure Figure 8: 8: Factors Constraining Infrastructure Development in in Indonesia (% (% of of respondents reporting the factor as as a Scarce) 70% 60% 50% 40% 30% 20% 10% 0% Lack of Co-ordination within Government Poor Quality of Bankable Projects Difficulty in Accessing land Weak Implementation Capacity Lack of Long-Term Finance Scarcity of International Financing Insufficient Investment Incentives Shortage of Managerial staff Scarcity of Local Financing Shortage of Technically Skilled labour Difficulty in Interfacing with Provincial Government Difficulty in Interfacing with Central Government Source: IDB (December 2009) Survey Conducted for the Country Diagnostic Study on Infrastructure Development in Indonesia Scarcity of Short-Term Finance Shortage of Artisans Shortage of Unskilled labour 18

37 percent of respondents identified that coordination among various tiers of government dealing with infrastructure was weak. The above three elements (i.e. lack of coordination, poor quality of bankable projects, and weak implementation capacity) are indicative of weak human and institutional capacity within government, and their scarcity was identified by stakeholders as constraining infrastructure investment. Concerns were also raised on the availability of land as 52 percent of respondents said that access to land was a hindrance to infrastructure development, particularly for road/ toll road, electricity, and communication. In addition, financing, especially long-term one, was highlighted as another bottleneck, with 48 percent of respondents citing it as being scarce. Other issues such as lack of investment incentives were also mentioned as a concern by 40 percent of respondents. This lack of incentive must be viewed in the context of the quality of the business climate and support from the government for new investment and business activities. This, along with shortages of skilled manpower (managerial staff and technical skilled labor), are also constraining factors. However, they are not binding, and could be resolved once the major constraints (institutional and human capacity, land acquisition and availability of finance) have been addressed. Cost Land acquisition was identified as the most significant constraining factor with 69 percent of respondents saying that acquiring land for infrastructure projects was quite costly. In addition, poor governance (rent-seeking activities) was cited by 58 percent as being high (Figure 9). The high cost of financing, especially short-term ones, also emerged as an issue along with business licensing (indicative of cost of doing business). However, labor (i.e., managerial, artisans, and unskilled labor) was not identified as costly by the respondents. Quality Bankable projects were identified by all respondents (100 percent) as being of poor quality (Figure 10). This highlights a fundamental capacity problem within the government, particularly in its ability to prepare proper bankable projects. It should be re-emphasized that respondents were from the public, private sector and institutions actively involved in the infrastructure sector either in an advisory or financing capacity. Hence, even within the public sector there is a strong sense that inadequate capacity is a constraint to prepare bankable projects. 19

38 70% 60% 50% 40% 30% 20% 10% 0% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Figure 9: Factors Constraining Infrastructure Development in Indonesia (% of respondents reporting the factor as Costly) High Cost of Land High "Rent-Seeking" Poor Quality of Bankable Projects Expensive Short-Term Finance Costly Business Licensing Weak Co-ordination between different tiers of Government Expensive Local Financing Costly Compliance to Environmental Legislation Ineffective Interface with Provincial Government Expensive Long-Term Finance High Local Government Taxes Source: IDB (December 2009) Surver Conducted for the Country Diagnostic Study on Infrastructure Development in Indonesia The level of coordination within the government was identified by 85 percent of respondents as weak. Interfacing with provincial governments was observed as ineffective by 67 percent of the respondents, while in the case of central government, only 46 percent had a similar perception. As such, it is apparent that quality concerns are more prevalent at the provincial level as compared to national level. This re-emphasizes the concerns about weak human and institutional capacity within the government, especially in local/ regional governments. Figure 10: Factors Constraining Infrastructure Development in Indonesia (% of respondents reporting the factor as Exhibiting Poor Quality) Weak Regulatory Environment Costly Legal Compliance High Tax Rates Inadequate Implementation Capacity High Cost of Doing business Poor Quality of Artisans Costly Compliance to Labour Regulation High Cost of Interfacing with Provincial Governments Ineffective Interface with Central Government Poor Quality of Unskilled labour Weak Labour Regulation Weak Tax Administration Poor Quality of Managerial staff Poor Quality of Technically skilled labour Source: IDB (December 2009) Surver Conducted for the Country Diagnostic Study on Infrastructure Development in Indonesia Expensive International Financing Costly Compliance to Tax Administration High Cost of Interfacing with Central Government High Cost of Technically skilled labour High Cost of Managerial staff High Unit Labour Cost High Wage rates High Cost of Unskilled labour High Cost of Artisans 20

39 70% 60% 50% 40% 30% 20% 10% 0% Figure 11: Factors Constraining Infrastructure Development in Indonesia (% of respondents reporting the factor as Adversely Impacting on Business) Access to Land Governance Co-ordination between different tiers of Government Government s Implementation Capacity Bankable Projects Local Government Taxes Interface with Provincial Government Compliance toenvironmental Legislation Legal and Regulatory Environment Interface with Central Government Long-Term Finance Local Financing International Financing Tariffs Setting by Government Tax Administration Artisans Business Licensing Investment Incentives Cost of Doing Business Technically Skilled Labour Unskilled Labour Labour Regulation Unit Labour Cost Tax Rates Managerial Staff Short-Term Finance Wage Rates Macroeconomic Stability Source: IDB (December 2009) Surver Conducted for the Country Diagnostic Study on Infrastructure Development in Indonesia ii) Impact of Scarcity, High Cost, and Poor Quality on Infrastructurerelated Business According to the survey, governance, access to land, human and institutional capacity within the government (derived from government coordination, implementation capacity, interface, and bankable projects), legal and regulatory framework, and long-term financing were highlighted as having the most adverse effect on infrastructure-related business (Figure 11). Macroeconomic stability was not cited by any respondent (zero percent) as adversely impacting on infrastructure-related business. This, along with wage rates and manpower at all levels, were highlighted as minor concerns. iii) Slow Improvement in Overall Business and Investment Climate for Infrastructure-related Business Over the Last Three Years On examining the improvement in various factors related to the overall business and investment climate for infrastructure development in Indonesia, it is apparent that there is little improvement on return on investment with 86 percent of stakeholders holding this view (Figure 12) This is consistent with the previous responses indicating the existence of a lack of investment incentives. The lack of improvement in the overall business climate is supported by the latest World Bank Doing Business 2010, wherein Indonesia s ranking has slipped on issues such as accessing credit (from 109 to 113), enforcing contracts (142 to 146), paying taxes (119 to 127), and improvement in terms of starting a business (from 173 to 161). 21

40 Figure 12: Lack of Improvement in Business and Investment Figure Climate 12: Lack for Infrastructure of Improvement Development in Business in and Indonesia Investment (% of respondents Climate for reporting Infrastructure the factor Development as Exhibiting in Indonesia No Improvement (% of respondents reporting the factor as Exhibiting No Improvement Over the Past Years) Over the Past Years) 90% 80% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Return on Investment Availability of Medium and Long -Term Finance (> 3 years) Availability of Short-Term Finance (less than 3 years) Shortages of Maintenance and Support Services Relationship with Tax Authorities Shortages of Machinery and Equipment Shortages of Skilled labour Shortages of Semi-Skilled Labour With respect to funding, the availability of medium- and long-term financing has not improved over the past three years, with 76 percent and 73 percent of all respondents citing no improvement both in medium-and long-term financing, and in short-term financing respectively. The survey indicates that, in the past, macroeconomic stability was maintained and viewed positively by investors, and both public investment and private saving do not seem to be critical constraints to investment on infrastructure. It suggests that key broad constraints, hindering the pace of infrastructure development, include problem in land acquisition and spatial planning, weak human and institutional capacity to implement projects, non-availability of long-term financing, and poor governance. By combining the constraints identified on the basis of available information and data, discussions held with the private and public sectors (between September 2009 and November 2009), and the results of the survey (which provided empirical support), the study has determined the key binding constraints to infrastructure investment. It is important to recognize that the study is not intended to provide a laundry list of constraints to be addressed in the medium- to long-term, but it rather focuses on the most (key) binding constraints that could be tackled over the short-term. The sub-sectoral analysis of the available information and data confirms the findings of both the discussions with the private and public sectors and survey. There are several cross-cutting constraints hampering infrastructure Shortages of Managerial Staff Relationship with Government Medium-Term Interest Rates (3-5 years) Short-Term Interest Rates (less than three years) Source: IDB (December 2009) Surver Conducted for the Country Diagnostic Study on Infrastructure Development in Indonesia Business Taxes Governance 22

41 investment in Indonesia that emerge from the analysis. The summary of binding constraints to sub-sectors is provided in Table 31. iv) Major Binding Constraints to Infrastructure Development On the basis of the survey results, the major constraints, which are identified by the respondents with their ranking, are reported in Table 4 and Figure Land acquisition is cited as the first major constraint to infrastructure investment, followed by weak human and institutional capacity (2 nd major constraint); governance (3 rd major constraint); and financing (4 th major constraint). The underlying reasons for all of these constraints emerge from the discussion in the following sections on sub-sector analysis of infrastructure. Major Constraints Table 4: Ranking of Factors Adversely Impacting on Infrastructure Development in Indonesia Scarcity Cost Impact % of respondents Rank** % of respondents Rank** % of respondents Rank** Overall Rank*** Difficulty in Land 52 2 nd 69 1 st 61 1 st 1 st Acquisition Weak Human 55 1 st 48 4 th 45 3 rd 2 nd & Institutional Capacity* Poor Governance N/A N/A 58 2 nd 58 2 nd 3 rd Shortage of Financing 45 3 rd 49 3 rd 34 4 th 4 th * This factor is the underlying issue behind the negative perspective on several areas including: Government Coordination, Bankable Projects, Implementation Capacity, Interface with the Government, and Legal and Regulatory Framework. ** The ranking of 1st, 2n, 3rd and 4th is based on the percentage of respondents saying as major constraints. *** The overall ranking is based on the weights (i.e. 50 to Scarcity, 30 to Cost and 20 to Impact. Source: IDB (December 2009) Survey Conducted for the Country Diagnostic Study on Infrastructure Development in Indonesia. V. SUB-SECTORAL ANALYSIS 19 Infrastructure encompasses several facets including power (all types), water supply, sewerage, communication, transportation (roads and bridges, seaports, airports, railways), housing, urban services, oil and gas production and mining. It is, however, not within the scope of this study to cover all infrastructure elements, but rather, to focus on the sub-sectors that are most critical for sustainable and inclusive growth in Indonesia. In this regard, this study restricts itself to analyzing the transport (roads, toll roads, railroads, air transport, and ports), electricity, and communication sectors. These sub-sectors 18 These findings are comparable to those of the Global Competitiveness Report ( ), wherein inefficient government bureaucracy (equivalent to weak human and institutional capacity) was the most cited problem, with corruption at number four, access to financing at number five, and labor and tax regulations as numbers six and seven, respectively. 19 More details on the individual sub-sectors are provided in Annexures B-G 23

42 Figure 13. Major Constraints to Infrastructure Investment in Indonesia (Based on Survey Results) 11 st st 2 nd 2 nd 3 rd rd 4 th Land Acquisition Problem Weak Human & Institutional Capacity Poor Governance Shortage of Financing are critical for sustainable and inclusive growth in many ways. For instance, industrial progress and agriculture development depend considerably on welldeveloped electricity, transport and communication sectors. In order to gain a deeper understanding of the underlying reasons for the inadequate quality and quantity of infrastructure in Indonesia, it is important to identify the key sub-sectors responsible for the lack of competitiveness in the sector. This would enable a more targeted and appropriate policy response. Once the key sub-sectors have been identified, their in-depth analysis is undertaken in order to determine binding constraints hampering investment in these sub-sectors. Quality of Infrastructure by Sub-Sectors A well-developed transport infrastructure plays a crucial role in economic development as improved communication network facilitates and enhances domestic and foreign trade. Among various modes of transportation, railways are considered most convenient and suitable for carrying heavy and bulky goods in the country. It also links various regions of the country and increases mobility of people. Similarly, an efficient road transportation is suitable for carrying perishable and less bulky goods. In particular, better rural roads often boost agricultural growth, thereby increasing rural incomes. As far as foreign trade is concerned, it is dominated by ports infrastructure as it is the cheapest mode of transportation for carrying bulky goods over long distances. Finally, 24

43 the trade of high value light goods and perishable items is largely carried by air. All of these types of transportation are critical for sustainable development in Indonesia. Reliable electricity supply is vital for rapid industrialization and agricultural development. All other sub-sectors of infrastructure like water supply, transport, and communication also need uninterrupted electricity supply. On the other hand, expensive and irregular electricity supply often impedes economic growth. This study attempts to find out which infrastructure sub-sectors are the major constraints to economic growth and why? There is little doubt that relaxing those constraints can help to accelerate inclusive economic growth. As a concomitant effect, removing those obstacles will also generate employment and reduce income inequality in the country. At the same time, addressing the issue of electricity, transport and communication can improve the investment climate in the country. Table 5: Quality of Infrastructure by Sub-Sector in Indonesia & Neighboring Countries, 2008 Indonesia Malaysia Thailand Philippines Vietnam Quality of roads Quality of railroad infrastructure Quality of port infrastructure Quality of air transport infrastructure Available seat kilometres Quality of electricity supply Telephone lines Source: World Economic Forum, Global Competitiveness Report, Note: The lower the ranking, the better the infrastructure quality. In 2008, the quality of infrastructure in Indonesia was far below Malaysia and Thailand, but at par with the Philippines and Vietnam 20. If one were to look at the details (Table 5), it is apparent that the areas in which Indonesia fares the worst is the quality of electricity supply, ports and roads. Of particular concern is the fact that both in 1991 and 2000, Indonesia s infrastructure was considered superior than in the Philippines and Vietnam. However, since 2005 these two countries were at par with Indonesia while Thailand and Malaysia were in a better state 21. This indicates that Indonesia has not been upgrading its infrastructure quality at the pace of its regional competitors. If this trend were to continue, Indonesia may soon find itself lagging behind all its regional competitors. 20 In 1996, Indonesian infrastructure was better than that of Thailand (and also China). 21 See Bhattachryay, 2009, p

44 Main Business Constraints by Sub-Sectors At the country level, transport is the second main obstacle to entrepreneurship identified by the business community in the recent 2003, 2005 and 2007 investment climate surveys, and electricity was rated as the 6th most important obstacle to their businesses. Apart from transport being identified as an important obstacle, the percent of respondents perceiving transport as a business constraint has increased from 29 percent in 2003 to 49 percent in 2009 (Figure 14), further validating the results of deteriorating infrastructure in the Global Competitiveness Report ( ). 60 Figure 14: Indonesia's Main Business Constraints (% of firms reporting the issue as a business constraint) Transport Electricity Communications Source: ADB and WB, Investment Climate and Productivity Study (2003, 2005 and 2007) Infrastructure Investment by Sub-Sectors The underlying reason for the poor performance of infrastructure at the sub-sectoral levels is directly attributable to the low levels of investment. An effective and efficient transport system, which is the foundation for a competitive economy (more so for countries wishing to pursue an exportled growth strategy), requires sustained high levels of investment. In the case of Indonesia, investment at the sub-sector level has been relatively low, particularly below 1.5 percent of GDP per annum for transport and communications. The electricity sector, which has also been identified as a constraint to business has had less than 1 percent of GDP being invested into it since 2000 (Figure 15). This does not bode well for the long-term sustainable growth of the economy, which depends on reliable, uninterrupted power 26

45 4.5 Figure 15: Infrastructure Investment by Sub-Sectors, (percent of GDP) Source: ADB, Water and Sanitation Energy Transport Telecoms Irrigation supply. Already, power outages have become a regular phenomenon and the situation is likely to get worse because of the declining performance of the existing power plants due to aging, i) Transport Efficient, reliable transport system is vital for any country s economic growth and development. A well-developed transport infrastructure helps to integrate the national market with different regions and other countries at low cost. At the same time, it enables less-developed communities to connect to core economic activities and basic services. On the other hand, when transport systems are inefficient and unreliable, they have a negative impact on the economy due to loss of business opportunities. Logistical performance Indonesia s performance is the worst on domestic transport costs. In terms of the ranking on the Logistical Performance Index (LPI), presented in Table 6, Indonesia s performance is the best on tracking and tracing, but worst on domestic logistics costs, which implies that the internal transport network is inefficient and places an undue burden on the private sector. On this indicator, Indonesia, which ranks 92, performs significantly worse than its regional competitors-- Malaysia (36), Thailand (25), and the Philippines (19). The best performer in this category is Vietnam, which ranks 17 out of the 150 countries rated. 27

46 Table 6: Logistical Performance Rankings 2007 (out of 150 countries) Indonesia Malaysia Thailand Vietnam Philippines Logistical Performance Index Customs Infrastructure International Shipments Logistical Competence Tracking & Tracing Domestic Logistics Costs Timelines Source: World Bank, Connecting to Compete. Trade Logistics in the Global Economy. The Logistics Performance Index and its Indicators. Note: The lower the ranking, the better the performance. Examining transport logistics in greater detail, Indonesia performs comparatively better on typical charges for both exports and imports of a 40- feet container. It also performs fairly well in terms of both export and import lead times (Table 7). The implication is that from a global trade perspective, the costs are competitive. However, of grave concern is the exorbitant domestic logistics costs highlighted earlier. Table 7: Selected Transport Logistics Issues (out of 150 countries), 2007 Indonesia Malaysia Thailand Vietnam Philippines Rate of Physical Inspection (%) Customs Clearance a (days) Lead Time b Export Median Case (days) Lead Time c Import Best Case (days) Lead Time d Import Median Case (days) Number of Border Agencies Exports Number of Border Agencies Imports Possibility of a Review Procedure e (%) Typical Charge f for a 40-feet Export Container or Semi-Trailer (US$) Typical Charge for a 40-feet Import Container or Semi-Trailer (US$) a Time taken between the submission of an accepted customs declaration and customs clearance b From shipper to port of loading. Median case = 50 percent of shipments c From port of discharge to consignee. Best case = 10 percent of shipments d From port of discharge to consignee. Median case = 50 percent of shipments e Percentages represent the proportion of respondents answering that a simple and inexpensive review is available. f Total cost to transport and port services Source: World Bank, Connecting to Compete. Trade Logistics in the Global Economy. The Logistics Performance Index and its Indicators. Quality of transport infrastructure Inadequate transport is a key constraint to business. In a recent survey by the OECD, approximately 50 percent of firms operating in Indonesia indicated that the inadequate supply of transportation infrastructure is a 28

47 (Rank out of 133 countries) Figure 16: Quality of Transport Infrastructure in Indonesia and Neighboring Countries, 2009 (ranking out of 133 countries, higher ranking indicates relatively poor quality) Quality of Roads Quality of Railroad Quality of Port Quality of Airport constraint for business growth (second most cited constraint) 22. The latest Global Competitiveness Report reinforces this view, mentioning that the quality of transportation infrastructure in Indonesia is way below its neighboring countries, such as Malaysia and Thailand, comparable to Vietnam, but ranks above the Philippines (Figure 16). Public expenditure in transport sector Public sector investment in the transportation sector is significantly below the requirements. Investment in road network development is undertaken by the Ministry of Public Works (MPW), while the Ministry of Transportation (MOT) is responsible for land transport traffic, railways, shipping and sea port, and airport development, and local governments are in charge of local transportation infrastructure. Public expenditure in the transportation sector has been steadily increasing with an annual growth of 30 percent between 2005 and In 2010, the allocated budget is about Rp 29 trillion, or about 0.48 percent of GDP, which accounts for about 2.9 percent of total budget. Public Service Obligation (PSO) expenditures consist of government subsidy to state-owned enterprises, and is provided to PELNI for pioneer shipping and serving economy-class passengers, railway operator KAI for economy-class passengers, and post operator POSINDO and the news agency ANTARA. The PSO has been a very small portion of GDP, amounting only to 0.03 percent of GDP, or about 0.15 percent of total budget in 2010 (Table 8). 22 OECD, (2008) Indonesia Vietnam Philippines Thailand Malaysia Source: World Economic Forum, Global Competitiveness Report Note: The lower the ranking, the better the infrastructure quality 29

48 Table 8: Government Expenditure in Transportation Sector (in billion rupiah) 2005 (audited) 2006 (audited) 2007 (audited) 2008 (audited) 2009 (revised budget) 2010 (budget) Transportation Expenditure 9, , , , , ,182.4 Public Service Obligation , , , , ,536.9 (PSO) Source: Budget Note 2010, Ministry of Finance Shares of various components of transport in transport infrastructure industry Roads and ports are the highest priority within the transport sector. Due to their critical importance in the economy, the shares of roads and ports in the transport sector have increased over time. For instance, the share of roads in total transport infrastructure industry increased from 33.4 percent in 2007 to 46.3 percent in 2009, and is projected to increase further to 53.9 percent in Similarly, the share of ports increased from 7.9 percent in 2007 to 20.7 percent in 2009, and is projected to increase to 24.6 percent in In contrast, the shares of railways and airports have significantly declined. For instance, the share of railways is projected to decline from 34.3 percent to 11.4 percent, and share of airports from 24.4 percent to 10.1 percent during the same period (Figure 17) Figure 17: Transport Infrastructure Value by its Components (% of total transports infrastructure) f 2010f 2011f 2012f 2013f 2014f Roads Railways Airports Ports Source: Business Monitor International Ltd. (Q1 2010) Indonesia Infrastructure Report 30

49 Road Transport Infrastructure The most important transportation mode in Indonesia is road network. Although, Indonesia is a big archipelago, inter-island and coastal shipping accounts for only 7 percent of freight and passenger movements, while roads carry 92 percent of total freight and 84 percent of passenger traffic. Rail accounts for around 1 percent freight and 7 percent passenger movement, with inland waterways and air transport carrying the remaining traffic 23. Indonesia s road density (defined as the ratio of total road network length to the size of the country) is 20, which is relatively small compared to Vietnam (68), the Philippines (67), Thailand (35) and Malaysia (28). A common indicator of general road quality is the extent of paved roads. Only 59 percent of roads in Indonesia are paved, which is far below compared to Thailand and Malaysia, but above the Philippines (Table 9). Table 9: Availability of Indonesia Road Network Indonesia 1/ Vietnam Philippines Thailand Malaysia Total Road Network (000 km) Paved Roads (percent) Road Density (km/100 sq km of land area) Source: World Development Indicators / Ministry of National Development Planning (2010), Sector Brief on Transportation. Although roads are critical for Indonesia s development, its growth has not kept pace with population increase. Road transportation accounts for the major share of freight and passenger traffic. So its widening coverage and quality are a prerequisite for supporting the country s economic growth and poverty reduction. What is worrisome is that the demand for better road transport has been growing at a faster pace than GDP for nearly a decade now. This trend is anticipated to continue in the foreseeable future, with traffic growth expected to increase at times that of GDP growth rates (roughly 7 to 10 percent per annum) 24. In addition, Indonesia s road network growth has not kept pace with the population increase during the recent years, underscoring a worrying trend that traffic congestion is becoming a serious problem. This is evident, especially in the arterial road network in Java. According to a World Bank appraisal 25, 43 percent of the road network in Java, and a higher proportion in Jakarta, are congested, resulting in longer travel times and higher cost. The appraisal also estimated that about 55 percent of the arterial network in Java will be congested by 2010, and indentified the need for about 2,000 km of toll road to mitigate the problem. 23 Transport Sector Strategy Study for Indonesia (ADB, 2004) 24 Strategic Road Infrastructure Project, Project Appraisal Document, World Bank, World Bank (September 2006), Country Assistance Strategy Report for Indonesia. 31

50 Another key concern is that 36 percent of the road network was either damaged or severely damaged at the end of 2007 (BPS 2007). Most of the damaged or severely damaged roads were under the purview of the district governments, and 39 percent of the 322,000 km of road under the district governments was considered damaged or severely damaged. The inefficiency, unreliability and high cost of road transportation is a key constraint to Indonesia s economic development, with the country having the highest logistics costs in Southeast Asia (see earlier section for a more detailed exposition on the Logistics Performance Index). This point is clearly illustrated by examining the road freight transport (Box 2). Public sector investment in roads Investment and maintenance of the road network are predominantly funded through the state-budget, including financial support from bilateral and Box 2: Road Freight Transportation A joint study conducted by the Asia Foundation and Indonesia s University of Institute for Economic and Social Research (LPEM) in 2007 found that road freight transport costs in Indonesia were driven up by local government charges, and rent-seeking activities by police and opportunistic behavior by unscrupulous individuals. It was estimated that such activities have raised operational costs by 10 percent, which impacts on the entire value chain. With the overall vehicle operating costs for trucks at 34 US cents per kilometer, the study concluded that Indonesia s logistics costs were higher than Vietnam, Thailand, Malaysia and China, whose costs are only 22 cents per km on average. This finding was supported by the Logistical Performance Index of the World Bank, wherein Indonesia ranked 92nd on domestic logistic costs compared to Malaysia at 36 th, Thailand at 25 th and Vietnam at 17 th. Over 35 trucks from more than 20 trucking firms were involved in the study. A surveyor, equipped with a global positioning system, was placed in participating trucks on nine different trading routes to obtain the direct costs paid by truck drivers during a trip. Six of the nine routes selected were in Sulawesi, other routes were in West Nusa Tenggara, East Java, and North Sumatera. For the Malang-Surabaya route in East Java, for instance, a truck, on average, needs to spend an additional Rp 6.4 million a month in operating costs, retributions and illegal fees. Most trucking firms were said to complain about the user charges issued by local governments, which were collected by different local administrations based on the type of goods loaded. Local administrations also charged fees for route permits and licenses. It may be noted that this is inconsistent with the national regulatory framework where route permits are required only for public transportation vehicles. However, in practice such permits are often demanded from cargo trucks passing between provincial districts. Hence, high vehicle maintenance and fuel costs, which arise due to the inadequate road infrastructure, are exacerbated by inconsistent user charges applied by the local government and rent-seeking activities. Source: Transportation Undermines RI Economy: Study. The Jakarta Post, April 16,

51 multilateral banks. It may be noted that the national budget is not supplemented by vehicle purchase and ownership taxes, which are appropriated by the local governments, and are thus not available for national road maintenance and investment. However, they could potentially be used for maintenance and investment of provincial/district roads. The Ministry of Public Work through the Directorate General of Highways (DGH) has significantly increased the road budget from Rp7.5 trillion in 2006 to about Rp20 trillion in 2009, with expenditure in 2010 estimated at over Rp24 trillion. The problem of poor quality roads is attributed to an appalling shortage of annual budget for road maintenance, which up to 2004 was less than Rp 1 trillion as against the required Rp20 trillion. However, the situation has been improving in recent years, with the government increasing the allocation for road maintenance from Rp3.8 trillion in 2006 to Rp12.1 trillion in 2009, and has budgeted Rp 14.4 trillion for It is worth noting that bulk of the national road budget (60.8 percent) was spent on maintenance in 2009, followed by 26.1 percent on investment in This highlights the government s commitment to maintaining existing infrastructure. However, the country is also in need of additional infrastructure, and this should be addressed by providing new investment in roads. Key constraints to public investment in road infrastructure Weak institutional capacity and lack of human capital: Due to decentralization, the responsibility for project implementation now rests with the local government. Capacity constraints at the local government level have hindered realization of budget allocations and project delivery. The lack of skills and limited operational capabilities within local government has led to delayed project implementation. In particular, capacity constraints have been found to be more prevalent in the area of project design and development, resulting in implementation delays. Responding to these constraints, DGH is taking a lead role in addressing the situation (especially for donor-funded projects) by: Implementing capacity-building program through on-call management support by the DGH staff to the local government staff; Using standardized bidding documents for both national and international competitive bidding procurement; and Implementing an electronic procurement system. While the large scale and long-term impact of these efforts remain to be seen, they are intended to mitigate the negative impact of decentralization. 33

52 Unsustainable public funding: Allocation for road projects (preservation, capacity expansion, and extension of the road network) has been inadequate since the financial crisis of 1997, and it has only started increasing in the last three years. This is particularly true for regional roads. The funding approved by the Parliament (through the national state budget and allocation of regional budgets) is expected to remain below the expenditure requirements over the coming decade. In addition, the prevalent public perception that road maintenance and development should be covered by state budget needs to be changed. Government should embrace the concept that cost for preserving and expanding the road network should be recovered through road users. Under-funding problems are compounded by unpredictability in the level of funding. To ensure adequate and sustainable financing of road preservation and extension, the government should consider the establishment of a road fund financed directly from road-user charges. The discussion on a road fund has been ongoing, and in order to address the issue of under-investment in road infrastructure, it is imperative that the appropriate legal framework for its implementation be established. Private Sector Investment in Road Infrastructure Private investment was first made in the development of toll road in 1990 through a build-operate-transfer (BOT) scheme between private operators and Jasa Marga, the state-owned toll road operator. Jasa Marga introduced a BOT system with revenue sharing (including sharing of land acquisition costs). By the enactment of Law 38/2004 on Roads and GR 15/2005 on Toll Roads, the government adopted a new regulatory framework for the sector. Under the framework, regulatory functions were transferred from Jasa Marga to the 34

53 newly established BPJT, with the expectation that their separation would avoid conflict of interest in Jasa Marga and, therefore, would attract more investors. Under the previous arrangement, Jasa Marga was automatically granted the concessions for all the existing toll roads it operated in The initial toll rate was agreed in the concession contracts, and tariff adjustments based on the consumer price index occur every two years. Currently, there are 697 km of toll roads in operations, of which about 77 percent are operated by Jasa Marga, and the rest by a private company (Annexure A). Most of the toll roads are located in Java, with a small portion in North Sumatera and South Sulawesi. Toll road projects are long-term investments with unique characteristics and specific risks. Most of the project costs (e.g., land and construction cost) are incurred at the beginning of the concession period, whereas the revenue stream only commences when the toll road begins its operation. The concession period for toll road projects in Indonesia ranges between 30 and 40 years, with payback periods between 20 and 25 years. For further toll road developments, the government is increasingly relying on private sector investment. In terms of project status, 20 out of the 24 toll road projects that have signed concession agreements are being stalled / held back by the process of land acquisition (some dating back to 1996). Hence, a key concern in toll road development is land acquisition. The responsibility for land acquisition for any public infrastructure rests with the government. For infrastructure projects undertaken as a public-private partnership, the regulation requires that prior to tendering process the government would prepare a land acquisition plan, finance and execute it accordingly. However, in practice this has not been fully implemented due to limited government budget allocations and the complexity of the acquisition process. Theoretically, the schedule for land acquisition is agreed upon in advance in the concession contract, with the government taking responsibility for acquiring the land and the private sector financing the acquisition. The pre-agreed land cost would be paid by the private investors after the land has been cleared completely for construction. This means that private investors would have full control over the start and completion of construction work, knowing in detail when they could expect to start commercial operation. However, in reality, the acquisition process implemented by the government takes a lot longer, resulting in financial loss and implementation delays for the private investors. Since 2006, BPJT has pursued a new policy regarding cost-sharing in land acquisition. The approach is that for financially viable toll road projects, the land cost should be borne by the investors and, therefore, form part of the 35

54 investment cost. For projects with marginal viability, the cost of land acquisition would be shared between the government and the private investors. In both cases, the maximum exposure to land cost increases for the private investors could be capped (e.g., 10 percent from the original land cost estimate) through the provision of government support. On the other hand, toll road projects that are not financially viable would be conducted solely as public projects. Key Constraints in Public-Private Partnerships and Private Investment Land acquisition problems: The core issue on land acquisition is not the availability of land, but rather, reaching a consensus on a suitable price. The negotiation is conducted between the government and the land owners. In most instances, these are lengthy and frustrating negotiations involving local government, land owners, non-government organizations providing advocacy to the affected people, and land speculators profiting from price escalation. This obviously exposes private investors to substantial risks of project implementation delays and cost overruns. From the financing perspective, banks have been very reluctant to lend money for land acquisition due to uncertainties surrounding costs and acquisition dates. Hence, toll road developers are dependent on equity to finance land acquisition. This arrangement is even more risky for the investors in urban toll road projects, where land cost can be as much as 50 percent of the total project cost. Both the processes of preparation and execution of land acquisition are lengthy and risky for the private investors. This risk and time delays have resulted in many projects being stalled or experiencing significant cost overruns, adversely impacting on return on investment, profitability and long-term commitment (Box 3). (See Annexure B for a detailed exposition on the land acquisition process and the steps taken by the government to address the issue). Lack of bankable projects: In 2007, BPJT invited tenders for 13 toll road projects under the Batch II package, but received only six bids. The tenders were subsequently cancelled due to lack of interest, and BPJT considered restructuring the project to be more attractive to private investors. Based on discussion with stakeholders from the private sector, the lack of interest from investors was due to the fact that the land for right of way (ROW) was not acquired for any of the 13 toll roads tendered. A further problem perceived by the investors was that the proposed concession agreements were not regarded as bankable. Hence, with Batch II, the risks for private investors, particularly 36

55 Box 3: Delayed and Costly Land Acquisition Process makes Project Unviable CMNP is the first private toll road operator in Indonesia with two operating projects in: (i) Jakarta Intra Urban Toll Road (JIUT) Section Cawang Tanjung Priok Jembatan Tiga; and (ii) Waru Juanda in Surabaya. In addition, it holds a concession for the Depok Antasari toll road in the South of Jakarta, which is currently at the land acquisition phase. The construction of the new Depok-Antasari toll road has been problematic due to delays in land acquisition for about two years now. The land acquisition cost was initially budgeted for about Rp 700 billion, but has since escalated to about Rp 1.8 trillion. As a result, the costs have gone up to such an extent that the financial viability of the project is now being questioned. The company is now under a three-way discussion with the Toll-Road Regulatory Agency (BPJT) and its bankers in order to seek government s assistance in paying part of land acquisition cost and renegotiating its concession agreement. In addition, it will need to develop a new business plan and prepare a new feasibility study for its financiers. with regard to land acquisition, were considered too high, and hence the lack of interest 26. Under the Batch III package, the Solo-Kertosono toll road project was highlighted as a model in public-private partnership, wherein the government committed itself to taking the responsibility for land acquisition. This also failed to elicit interest from investors when it was tendered in 2007 (only one bid was received). Although the risk of land acquisition rested with the government, the project itself had low returns on investment, and was not considered viable unless the government was willing to bear more construction cost. The government is now entering into a direct negotiation with the sole bidder and is yet to finalize the concession agreement. To date, no further tenders for new toll road projects are underway. The BPJT is now focusing on resolving the problems with old toll road projects whose concession contracts were awarded prior to the financial crisis of Resolution of these projects would still entail the same issues: land acquisition and the type and amount of the government support required to facilitate financial viability and closure. Non-availability of long-term financing: The other key constraint is nonavailability of long-term financing, which is required by the private sector for road infrastructure projects. Commercial banks in Indonesia are only willing to provide financing for a period of up to seven years, state-owned banks may go up to 12 years while road infrastructure projects require financing beyond that time. Hence, the lack of long-term financing is largely due to the 26 These issues were highlighted in discussion held with key stakeholders in the infrastructure sector (July2009-November 2009). 37

56 mismatch between the time-horizon for commercial bank sources of funding (short-term) and financing requirements for infrastructure projects (mediumto long-term). In this context, it is important that banks diversify their funding sources to include more longer-term financing, either by developing a domestic bond market (preferred option), issuing global bonds or through long-term borrowing from international banks. On the basis of the above analysis, the key constraints hampering new investment in road infrastructure in Indonesia are summarized in Table 10. Arguably, the issue of land acquisition is the most binding constraint, followed by the lack of institutional and human capacity within the government (which manifests itself in the inability to prepare bankable projects and implement government regulations); lack of bankable projects; and lack of long-term funding. Table 10: Summary of Major and Minor Constraints to Road Infrastructure Constraints Major/Minor Constraints Land Acquisition problem Weak Institutional Capacity and Lack of Human Capital Lack of Bankable Projects Poor Governance Non-availability of Long-term Funding Key: : Major Constraint : Minor Constraint ii) Ports Sea transport is of vital importance to Indonesia, as the country is the largest archipelago in the world, with more than 17,000 islands. The country s sea area is approximately 7.9 million square-kilometres, about four times its land area. Given this geographic condition, Indonesia is heavily dependent on maritime transport for international as well as domestic trade. Patunru et al (2007) indicated that about 90 percent of Indonesia s external trade is conducted through sea ports. Inter-island and coastal shipping accounts for about 7 percent of total national freight and passenger movements, second after road transportation. It is not surprising that the development of shipping and port services throughout the country is one of government s top priorities. Overview of the Sector Volume of domestic passengers using sea transportation is decreasing overtime. In particular, passenger sea transportation has been effectively declining over the last four years due to competition from air transport. Table 11 shows passengers traveling by sea have declined by an average of 24.7 percent per 38

57 annum from 2004 to 2008, while inter-island shipping cargo has increased annually by 6.4 percent over the same period. Table 11: Volume of Passengers and Cargo for Domestic Sea Transport trend growth (%) Passengers (million persons) Cargo (million tons) Source: BPS, 2009 and Ministry of Transportation, 2009 Volume of international sea transportation serving exports/imports is steadily increasing. From 2004 to 2008, total volume of international cargo through sea transportation in Indonesia grew by 3.7 percent annually, with foreign ships dominating with about 92 percent market share. However, Indonesian ships serving international cargo increased by 21.5 percent annually, while foreign ships rose by 2.8 percent annually (Table 12). Table 12: Volume of Exports/Imports Through Sea Transport trend growth Domestic shipping (million tons) Foreign Shipping (million tons) Total (million tons) Source: Ministry of Transportation, 2009 Ports performance lags behind compared to other major ports in Southeast Asia. Most container cargo in Indonesia is processed through the three main container terminals: Tanjung Priok in Jakarta, Tanjung Perak in Surabaya, and Tanjung Emas in Semarang. Tanjung Priok, with a total peak throughput of 4.2 million twenty-foot equivalent units, is the country s largest international container terminal. However, Tanjung Priok s performance lags behind other major ports in Southeast Asia. In volume of container handling, Tanjung Priok ranked 24 th of the 50 major ports in the 2005 World Port Rankings (World Container Port League 2005). In comparison, Singapore s port was ranked 1 st, Port Klang in Malaysia was 14 th, and Laem Chabang in Thailand was 20 th. The only major port ranking below Tanjung Priok was Manila Port in the Philippines, which was ranked 31 st. Other performance comparisons suggest that Tanjung Priok is also less competitive in terms of length and number of bureaucratic process for clearance, waiting time, and port access. Hence, performance lags behind that of most other major ports in Southeast Asia. Indonesia s connectivity index has been falling. During , connectivity index (LSCI) in Indonesia remained far below Malaysia and 39

58 Thailand (both have been consistently rising since 2004), and only above the Philippines. In terms of average annual growth, LSCI of Indonesia showed negative growth of 1.3 percent during , compared to 13.9 percent growth in Vietnam, 6.5 percent in the Philippines, 5.8 percent in Malaysia, and 3.8 percent in Thailand during the same period (Table 13). Table 13: UNCTAD Liner Shipping Connectivity Index (LSCI) * trend growth (%) Indonesia Malaysia Thailand Vietnam Philippines Source: UNCTAD, 2009 Note: The lower the index, the poor the liner shipping connectivity. * The LSCI captures a country s level of integration into global liner shipping networks. It combines fleet assignment, lines services as well as vessel and fleet sizes. It provides a comparative indication of the level of shipping services in a country. Key Constraints to Public Sector Investment in Ports Infrastructure Weak Human and Institutional Capacity: MOT together with JICA conducted a study on port productivity and service levels in Indonesia. The finding, based on inputs and discussion with port users, is summed up below: Findings Underlying Reasons Low productivity and poor service Non-efficient work method Lack of personnel integrity No transparency Lack of use of information technology Long delay for importation Long bureaucratic and inefficient process Small cargo throughput Low export volume Low of country competitiveness Congested and low quality port access road Source: STRAMINDO - JICA Study, 2005 Poor planning Poor transportation management Low investment on access roads These findings are supported by Patunru et al (2009), who noted that soft infrastructure could play a more vital role in eliminating major constraints in port efficiency than the physical infrastructure. The competitiveness of a seaport may suffer from poor physical infrastructure such as inadequate port depth, short berths, and limited cargo-handling equipment, storage and transit areas, but it may also suffer from limitations in soft infrastructure, such as weak labor skills, inadequate labor regulation, stifling bureaucratic 40

59 red tape, and other regulatory factors (such as the use of shipping flag). Lack of competition between ports controlled by state-owned operators is also a critical factor impacting on port performances. Non-conducive labor regulations effectively institutionalize underutilization of port facilities and limit the potential for efficiency improvements. In many ports, only one shift of labor is provided and opportunities for overtime are limited. Nathan Associate (2001) observed that this regulation results in a loss of 6-hour productivity out of every 24-hour operation because the rigid break time is not staggered to ensure continuous servicing of vessels. Higher Rent-seeking: Another cause of poor port performance is corruption. Patunru (2007) notes that use of informal payments to speed up queuing time resulting from the lack of key infrastructure facilities such as gantry cranes and storage space are a common occurrence. Such costs are in addition to a broad range of informal payments required at the port for export and import procedures. The media regularly reports about this phenomenon. Geographic Constraints: Indonesia has very few natural deep-water harbors and has a river system prone to serious siltation that restricts port depth. Ray (2006) noted that port depth appears to be a major problem for almost every port in Indonesia. To operate normally, many ports have to undertake continuous dredging, which is expensive. This geological condition is especially true for the main ports located on the northern coast of Java, which service the most populous and industrialized regions of the country. The seabed and coastal soil are mainly alluvial and unstable coupled with shallow coastal waters. Hence, finding appropriate sites for new port development is difficult. Soil investigations conducted by civil engineers found that to have an acceptable draft of at least 12 meters, a jetty as long as 3 km would have to be constructed from the Northern coast of Central Java. The Port of Semarang, the main seaport for Central Java, is also problematic since it is sinking at a rate of 7-12 cm per year, and for many days of the month large parts of the port remain underwater. Every 7-10 years, the container terminal must go through an expensive and time-consuming process to elevate the main wharf and container storage area. Private Sector Investment and Public-Private Partnerships (PPP) Private investment in ports has had mixed results. PPP in port started in 1995 with the concession granted to Hutchison Whampoa for the rehabilitation and operation of Koja Container Terminal for 20 years (Table 14). Full private investment has been conducted successfully for bulk supply terminal serving coal miners as done by Adaro Energy and Dermaga Prakasa Pratama in Kalimantan. Both terminals are serving the domestic and international coal 41

60 markets, which are growing. To raise financing during the Asian financial crisis, the government embarked on an additional PPP through partial privatization by the sale of 52 percent of Jakarta International Container Terminal (JICT) to Hutchison, and 49 percent of Tanjung Perak Container Terminal to P&O (DP World), both in These joint ventures have not been really successful, with the private investors being accused of not achieving target performance and failing to attract sufficient traffic to the Port. PPP Contracting Authority is still performed by state-owned operators, which is clearly a conflict of interest. Most major commercial seaports are operated by the four PELINDOs (the state-owned companies), who until the new maritime law becomes effective in 2011, act as monopolies managing all aspects of operation, development, and solicitation of private sector participation. They would also act as regulators, setting tariff for the use of port infrastructure and services in consultation with the MOT. These circumstances and lack of a level playing field (PELINDOs as port operator are also competing with the private operators) have created uncertainties and an unpredictable regulatory and investment environment, resulting in low private sector participation in the port sector since Table 14: Private Investment and Public-Private Partnerships in Indonesian Sea Ports Name Mobility Contract Period Sponsor Start Year Investment ($ million) Koja Container Terminal ROT 20 Hutchison Whampoa Indonesia Bulk Terminal BOO - Adaro Energy Balikpapan Coal Terminal BOO - Dermaga Prakasa Pratama Tanjung Perak Container Terminal BROT 20 DP World Jakarta International Container BROT 20 Hutchison Whampoa Terminal Peti Kemas Makassar ROT 10 ICTSI 2003 Source: World Bank PPI Database, 2009; ROT: rehabilitate, operate, transfer; BOO: build, own, operate; BROT: build, rehabilitate, operate, transfer. Key Constraints in Public-Private Partnerships and Private Investment Weak Regulatory Framework: Private investment in port infrastructure has been low due to lack of clear and predictable regulatory environment. Prior to the issuance of the new maritime law (Law 17/2008), PELINDOs were acting both as a landlord and an operator under the PPP contract. This deterred private investment as potential investors in PPP projects were not receiving fair treatment. Under the new Law (in which PELINDOs monopoly powers are revoked and they become ordinary port operators), the role of landlord 42

61 would be conducted by a port authority, which would act on behalf of the government. Under this structure, the division of responsibilities between the public authority and private investor in a PPP contract becomes clearer, and removes the conflict of interest. Unfortunately, the regulation, which would act as a guideline for the establishment and operationalization of port authority, will not be in force until the law becomes effective in Weak Institutional Capacity: Government officials both at the MOT (for national port projects) and regional levels (for regional ports) do not have the required capacity to structure internationally acceptable bankable PPP projects. Historically, the contracting authority s role was performed by PELINDO, with the government responsible for policy making. Hence, skills were not developed within the government to function as a contracting authority. To resolve this problem, MOT has requested assistance from Project Development Facility from the PPP Center Unit within BAPPENAS. This is intended to recruit experienced transaction advisors aimed at helping MOT and regional government structure so that they can prepare an attractive port project and bankable port concession agreement. The new maritime law specifies in significant detail the tasks and functions of Port Authorities, such as planning, oversight of terminal and award of concessions. The law specifically requires that Port Authorities be staffed by civil servants with appropriate qualifications and experience. Such personnel are available in Indonesia, but tend to be in the payroll of the four PELINDOs. MOT, on the other hand, lacks civil servants with relevant expertise and experience. A rigid requirement for Port Authorities to employ only civil 43

62 servants could potentially impede as opposed to facilitate new investment and the required operational improvements in the major ports. Lack of Bankable Projects: One additional constraint to the implementation of port PPP is that no bankable project has been offered so far to potential investors. Partial privatization of Tanjung Priok and Tanjung Perak in 1999 were considered more as a fund-raising effort by the government during the Asian financial crisis, and not from the perspective of utilizing private investor s expertise to increase port productivity. Subsequent efforts to offer Bojonegara Port in West Java and Lamong Bay Port in East Java have not materialized, as the government is still structuring the deals for them to be more attractive for private investors (e.g., establishing the port authority and acquiring the land prior to floating tender). These two projects have actually been under preparation for tender since 2006, but the process has been agonizingly slow due to the weak institutional capacity. Perceived Low Return on Investment: Under the new sea transportation law, the government still controls tariffs for PPP port projects. The tariffs are set by the port authority after consultation with the MOT. This may not be unexpected, considering that ports have substantial geographic monopoly, and as there would be no introduction of intra-port competition, tariff regulation is quite discouraging. Private investors would expect that port tariffs should actually be determined through a competitive bidding process during the selection of a port investor. Application of cost-of-service or rate-of-return regulation would generally result in tariffs too low to generate enough interest from potential investors. Table 15: Summary of Major and Minor Constraints to Ports Infrastructure Constraints Major/Minor Constraints Weak Human and Institutional Capacity Weak Regulatory Framework Higher rent-seeking Lack of Bankable Projects Shortage of Low-Term Finance Received Low Return on Investment Geographic Constraints Key: : Major Constraint : Minor Constraint 44

63 The above analysis highlights that the key constraints hampering new investment in seaports include the lack of institutional and human capacity within government and the inability to prepare bankable projects and corruption/ rent seeking activities, weak regulatory framework, and low returns on investment (Table 15). iii) Railways Railways are probably the safest means of land transport and can accommodate high volumes of passengers and freight while being energy efficient. It is, however, less flexible and more capital intensive than road transport. It is, nonetheless, important, especially in populous regions, to support population mobility and inter-regional freight transport. Overview of Railways Sector Growth in usage of railways is marginal. The total number of railway passengers in Java and Sumatera rose from 155 million in 2003 to 175 million in 2007, an increase of 3.2 percent per annum. Similarly, the total number of kilometres increased by 1.6 percent during the same period. This increase occurred mainly in Java, which, in 2007, carried 98 percent of rail passengers (Table 16). Table 16: Railways Transportation in Indonesia, trend growth (%) Passenger embarked (million in number) Jawa Sumatera Total Passenger travelled (million km) Jawa 14,251 13,991 13,610 14,799 15, Sumatera Total 15,031 14,777 14,345 15,579 15, Average Length of Journey per passenger (km) Jawa Sumatera Total Freight Transportation (000 Ton loaded) Jawa Sumatera 3,389 3,638 3,499 3,612 3, Total (million Ton km) 4,356 4,580 4,432 4,474 4, Jawa 4,559 4,466 4,439 3,900 3, Sumatera 11,734 12,680 12,882 13,373 13, Total 16,293 17,146 17,341 17,273 17, Average of Distance freight transported (km) Jawa Sumatera Total Source: Statistical Yearbook of Indonesia,

64 Freight transportation by rail remained around 4.4 million ton during , with a marginal annual increase of only 0.1 percent. In terms of railways freight transportation, Sumatera accounts for around 80 percent (Table 16). Most railway assets are old and deteriorating (e.g., over two-thirds of serviceable rolling stock is over 20 years old). Indonesia s railway sector accounts for less than 10 percent of total passenger traffic and only 0.6 percent of freight traffic 27. Compared to neighboring countries in the region, Indonesia has the largest rail network (4,337 km) and the most intensive use of railways (25.5 billion-passenger- km) (Table 17). Table 17: Railways Statistics in Indonesia and Neighboring Countries, 2006 Indonesia Vietnam Philippines Thailand Malaysia Rail lines route (km) 4,337 3, ,044 1,667 Passengers carried 25,535 4, ,195 2,075 (million-passenger-km) Good hauled (million-ton-km) 4,698 3,447 na 4,037 1,572 Source: World Development Indicators 2009 Indonesia s rail network is only in Java and Sumatera. Although it measures 5,824 km, only 4,337 km are operational. Java has a larger rail network than Sumatera, with major rail corridors being Jakarta-Bandung, Jakarta-Semarang- Surabaya-Banyuwangi (known as the North Route), Bandung-Kroya- Yogyakarta-Surabaya (known as the South Route), and with the connector route of Cirebon-Purwokerto-Kroya. Most of the railway system is singletrack, but due to the growing demand for mass urban transport, the government intends to improve the capacity and quality of the Jabotabek railways network, which comprises nearly 266 km of double-track. The expansion of the railways continues to be plagued by land acquisition issues. Millions of passengers in Jabotabek tend to use rail for relatively short distances, while in Sumatera, the railways are mainly used for coal and commodity transport. Key Constraints in Public Sector Investment in Railway Infrastructure Weak Human and Institutional Capacity: Under the old law, development and implementation of the railway services were predominantly conducted by PTKA, with policy-making and tariff regulations under the domain of MOT. This arrangement resulted in PTKA having 23,000 staff, compared to the newly established Directorate General of Railways (DGR) under the MOT, which 27 ADB, Indonesia Infrastructure Reform Sector Development Program Loan Sub-Program 2,

65 has only about 300 full time staff. At the local government level (Province or District), this number drops to zero in some instances. The lack of sufficient competent staff will need to be addressed if the DGR is to carry out its policy and regulatory functions efficiently and effectively. Staff transfer from PTKA to DGR or effective resource management and extensive capacity-building program would, therefore, be necessary to strengthen DGR performance. Land Acquisition: This commonly identified constraint is the most critical impediment to investment in expanding the rail infrastructure. The National Land Agency, along with an inter-ministerial coordination group under the Coordinating Ministry of Economic Affairs, has been established to develop appropriate laws and regulations aimed at simplifying and accelerating the land acquisition process. It is a major constraint for Jabodetabek network in Greater Jakarta, stalling the construction of the railway expansion (Box 4). Box 4: Land Acquisitions for Railways Expansion: Jabodetabek Network in Greater Jakarta The Government of Indonesia planned to build a double track railway line connecting Manggarai and Bekasi. The project has been in the pipeline for over three years, but cannot progress due to unresolved land acquisition issues. The government anticipated that the land acquisition would be completed by the end of 2009, with construction of the project finished by The key problem is related to procurement of land (which incidentally is owned by retiree of PTKA). Low Return on Investment: Train fares are determined based on social consideration, which often leads to a lack of sustainability of services. This has also resulted in dependency on government budget for subsidizing operating costs. Private Sector Investment and PPP in Railways Infrastructure No significant private sector investment in railways sector. Under the previous law, private sector participation in the railways could be conducted through joint ventures with PTKA. However, nothing materialized due to lack of transparency in the financial arrangements between the government and PTKA. Hence, private sector involvement in the existing railway network is very difficult. To date, there is no real PPP, with the only partnership being between PTKA and the state-owned Angkasa Pura II to bid for the PPP raillink connecting Sukarno-Hatta Airport with downtown Jakarta. 47

66 Key Constraints to PPP and Private Investment in Railways Infrastructure Weak Regulatory Framework: As with other transportation sectors, new laws and regulations were developed, but they still lack clarity in PPP. According to the World Bank s assessment, although the law mandated that PTKA would be at a level playing field with other private sector operators, the KAI s monopoly would be maintained, and that private investment in railways would be limited to a minority shareholding in the national railways company, with the private sector not allowed to operate its own rolling stocks (World Bank, 2008). Weak Institutional Capacity: The contracting responsibilities for railways infrastructure are held by MOT, which lacks experience, resources, and the capacity to prepare and structure as PPP project. This weakness was evident during the preparation and implementation of PPP Sukarno Hatta rail-link project, wherein the project was structured without government support, resulting in a non-bankable project agreement 28. For the next planned PPP project on coal-railways in Kalimantan, the MOT and the Provincial Government of Central Kalimantan, with the help of BAPPENAS, are working side-by-side with transaction consultants to market and tender out the project. This opportunity to have on-the-job training with experienced international consultants may accelerate the learning process while simultaneously achieving success in PPP project implementation. Perceived Low Return on Investment: Under the new railways law, the government controls track access charges (TAC) through MOT. The regulation for calculating and setting TAC is not enacted yet, resulting in uncertainty as the private sector investors need to wait for it before taking any decision to participate in PPP projects. The details on TAC are very important to a PPP, since it determines project viability. If a similar TAC arrangement with PTKA is applied, the private sector may perceive that the rate of return on the project is too low to justify participation. The above analysis highlights that the key constraints hampering new investment in railways infrastructure include the lack of human and institutional capacity within the government; land acquisition problem; weak regulatory framework, and low return on investment (Table 18). 28 Tempo Interaktif, Pemerintah Batal Ambil Alih Proyek Kereta Bandara Sukarno-Hatta, June 29,

67 Table 18: Summary of Major and Minor Constraints to Railways Infrastructure Constraints Major/Minor Constraints Weak Human and Institutional Capacity Difficulty in Land Acquisition Poor Governance Weak Regulatory Framework Low Return on Investment Key: : Major Constraint : Minor Constraint iv) Airports Air transport plays a key role in the Indonesian economy by offering fast mobility, supporting economic activity, and providing the fastest lifeline access to remote areas across the vast archipelago. The low-cost airline carriers have captured a significant share of domestic passengers from sea transportation. Overview of Air Transportation Sector Growth in this sector is driven by increased competition and the availability of low-cost air carriers. The deregulation of the airline industry, commenced in 1999, facilitated private airlines to compete with state-owned carriers. The greatest beneficiary of this has been the consumers, who have seen drastic drop in fares and additional scheduled flights to new destinations. The number of air passengers grew from 23.8 million in 2004 to 37.4 million in The annual growth during that period was 12.8 percent for domestic and 8.8 percent for international flights (Table 19). Given the geographical spread of Indonesia, the expansion of low-cost air travel is seen as a major contributor to social development and economic growth. Although the economic prospects for the aviation industry look positive, overcrowded airport terminals (especially in regional hubs like Polonia Medan and Djuanda Surabaya) 29, inadequate air traffic control, and safety issues could hinder its growth. Table 19: Air Passenger Volumes for Indonesian Airports trend growth (%) Domestic flight (million) International flight (million) Source: Ministry of Transportation, 2008 Airline accidents are way above average. The rate of fatal air accidents is 15 times the world average 30. A government-funded study on airline safety 29 ADB, Indonesia Country Strategy and Program World Bank, Infrastructure Development Loan Program Document,

68 reported that none of Indonesia s airlines was fully compliant with international safety standards. The government took action to rectify the situation, enforcing stringent controls over flight standards. By 2008, the number of casualties had decreased significantly compared to 2007 (Table 20). Table 20: Air Transport Accidents in Indonesia Number of accidents Number of fatal casualties Source: MOT, 2009; National Transport Safety Committee, 2009 Air transportation in Indonesia has significant growth potential. Compared to its neighbors, on a per capita basis, Indonesia passenger traffic (13 passengers/100 inhabitants) is marginally higher than Vietnam (8 passengers/100 inhabitants) and the Philippines (10 passengers/100 inhabitants), but significantly lower than Malaysia (80 passengers/100 inhabitants) and Thailand (33 passengers/100 inhabitants). In terms of airfreight, Indonesia is ahead of Vietnam and the Philippines, but far below Malaysia and Thailand. However, in terms of registered carrier departures worldwide and passengers carried, Indonesia is ahead of all its neigboring countries (Table 21). Table 21: Air Transport Statistics in Indonesia and Neighboring Countries, 2007 Indonesia Vietnam Philippines Thailand Malaysia Registered carriers departures worldwide (thousands) Passengers carried (thousands) 30,406 7,194 8,818 21,192 21,326 Airfreight (million ton-km) ,455 2,662 Population (million) Passengers/100 inhabitants Source: World Development Indicators 2009 Public Investment in Airport Infrastructure Long-term public funding for airport development is rare. While private airlines have responded quickly to market liberalization, airport infrastructure, which is still largely under the public domain, has grown at a slower pace. Due to government-determined domestic airport tariffs (which are low), there is a lack of profitability on services provided. Only major hubs (e.g., Jakarta, Medan, Surabaya, and Bali), controlled by the APs with significant international traffic, are able to break even in their operations. Although the airport operator could propose tariff increases, this can only be done after consultation with users, local governments, and the MOT. Experience with tariff increases indicates that they are difficult to implement due to strong 50

69 resistance during the consultation process, or could even later be challenged in court by consumer groups 31. With this pricing practice, it is difficult for both APs and the government to provide long-term funding for expansion or new airport development. Analysis of APs financial statements highlights that their revenue management is also not optimal, with more than 70 percent of their revenue accruing from aeronautical fees (Table 22). The possibility of diversifying into other revenue sources was only recognized in the last five years and reflected in plans for future development, which includes the development of sophisticated retail facilities and supporting infrastructure (e.g., railway access to the airports). Hence, the share of non-aeronautical revenue is growing since Table 22: Angkasa Pura 1 Revenue (billion rupiah) Aeronautic ,021 1,178 1,415 Non Aeronautic Total Revenue 1,063 1,215 1,311 1,549 1,861 Aeronautic share (%) Source: Angkasa Pura 1, 2008 There is also the lack of an established funding policy and mechanisms for central/local government, APs, and private sector on how to finance new airport projects. The use of foreign loans from multilateral or bilateral agencies to finance expansion of major airports is also restricted, since most of them (e.g., Polonia Medan and Adi Sutjipto Yogjakarta, except for Sukarno-Hatta in Jakarta) are used for both civilian and military purposes. Key Constraints to Public Sector Investment in Airport Infrastructure Weak Human and Institutional Capacity: This is manifested in the high rate of air accidents. The investigation by the National Transportation Safety Committee indicated that percent of the accidents occurred as a result of inadequacies in human capacity (errors by pilots, air traffic controllers, and maintenance crews). Institutional weaknesses are also apparent in the limited supervision for flight-worthiness tests and procedures. The new aviation law requires the creation of a single air traffic controller, which will assume the roles currently handled by the APs and MOT. The law does not stipulate that the new air traffic controller must be staffed by civil servants (as in the case for the establishment of port authority in the maritime law). This could be 31 Warta Ekonomi, Kenaikan Airport Tax Digugat Pengguna Layanan (Increase of Airport Tax Challenged by the Service Users), May 1,

70 exploited by the air traffic controller to employ appropriately skilled and incentivized staff. Public investment in the air traffic controller and other safety-related institutions is crucial for the sector s future growth. Weak Funding Capacity for Non-commercial Airports: The operation of large and profitable airports is conducted by the APs, while unprofitable remote airports are conducted by the MOT. The APs have brought professionalism and customer-oriented services to the airports under their control. On the other hand, the burden of managing the low traffic and loss-making airports rests with the MOT, which depends on state budget to cover expenses. This arrangement has made it difficult for MOT to build capacity and resources to adequately maintain existing facilities or invest in new ones. Private Sector Investment and PPP in Airport Infrastructure No significant private investment in the airport sector. Private sector participation in airport development and management was limited to the APs sub-contracting terminal services. Overall privatization of the APs or implementation of PPP on some major hubs was considered by the government, but no significant progress has been made. Until the effective implementation of the new aviation law (through the issuance of the implementing regulations), a viable public-private partnerships in airport operation is limited only through joint-venture with the APs, which have been offering partnerships in terminal operation or rail access. To date, there is no real PPP, except for the joint venture designed to develop the raillink connecting Sukarno-Hatta Airport with downtown Jakarta (between AP and the state-owned railway operator PT Kereta Api). Key Constraints to PPP and Private Investment in Airport Infrastructure Weak Regulatory Framework: Private sector participation was low in the air transport sector due largely to the lack of a level-playing field providing equal access and opportunities to all investors, and the absence of a clear and predictable regulatory and investment environment. In addition, the private sector is currently excluded by design because the provision of certain services is restricted to the public sector. Under the previous law, commercial airport operations were conducted by the APs, which limited options for PPP transactions to the provision of terminal service, while keeping the lucrative air-side business for itself. The new law separates the air traffic control function from the APs. However, their existing position would give them the early advantage to maintain and expand their market share in Indonesian airports. The new law would also transfer the contracting power to MOT and local 52

71 governments, whose detailed jurisdiction and authority to run airports are yet to be established. The regulation laying the legal foundation for the airport contracting authority is still being drafted. As such, there is still a high degree of uncertainty among private investors. Hence, it would be premature to take investment decisions until clarity on the legal and regulatory framework emerges. Weak Institutional Capacity: The MOT and the local governments lack experience, resources, and capacity to prepare and structure PPP projects. The case is evident in the request from Project Development Facility (PDF) in BAPPENAS for the preparation and transaction of the PPP for the West Java International Airport in Kertajati. Perceived Low Return on Investment: Under the new air transportation law, the government still maintains control of airport service charges through consultation with MOT. Since an independent regulatory body is absent in this regard, resistance to increases in airport fees may adversely affect investors since tariffs could be set based on consumer/political considerations. Based on the above analysis, Table 23 highlights key constraints hampering new investment in air transport infrastructure. They include weak human and institutional capacity within the government; weak regulatory framework; rare long-term funding; weak funding capacity for non-commercial airports; and low return on investment. Table 23: Summary of Major and Minor Constraints to Airport Infrastructure Constraints Major/Minor Constraints Weak Human and Institutional Capacity Weak Regulatory Framework Shortage of Long-term Funding Perceived Low Return on Investment Weak Funding Capacity for Non-commercial Airports Key: : Major Constraint : Minor Constraint v) Electricity Irregular and quality of electricity supply is a key constraint to business growth as stated by 43 percent of Indonesian businesses surveyed in the 2008 OECD study 32. This is not surprising since the electricity sector is characterized by: 32 OECD (2008) 53

72 low-levels of electrification ranging from 21 percent in East Nusa Tenggara to 88 percent in the capital city of Jakarta. The overall country electrification rate increased from 55 percent in 2003 to 65 percent in 2009; persistent high transmission and distribution (T&D) losses of over 11 percent since 1997; unsustainable subsidized nation-wide uniform electricity tariffs that are set below cost-recovery levels (set by the President after consulting with Parliament); suppressed demand - new connections could not be quickly established due to lack of supply to maintain a safe level of reserve margin 33. Overview of Electricity Sector Before the 1997 Asian crisis, Indonesia experienced an annual growth in electricity consumption of over 13 percent, peaking in at over 15 percent. However, after the crisis, the annual average electricity consumption growth dropped to around 7 percent and further fell to 2.6 percent in During the period , PLN s installed capacity grew at 2.4 percent annually, and by 1.5 percent from 2007 to This resulted in suppressed demand due to lack of generation capacity. During the Asian crisis, PLN s average tariff in dollar terms fell sharply and resulted in huge financial losses for PLN, adversely impacting its ability to invest in new capacity to meet the growing demand (Table 24). The Asian crisis resulted in a rapid depreciation `of the Rupiah against the US dollar, and since costs were dollar based whilst revenue was in Rupiah, losses were higher 34. The outcome of the lack of investment was a decline in the performance of its aging facilities, further exacerbating power shortages, particularly outside the Java-Bali power system (e.g., North Sumatera, Riau, East Kalimantan). Indonesia had an installed generating capacity of about 44.5 gigawatts at the end of 2007, about 57 percent of which was owned by the state-owned PLN. Of the privately-owned generation capacity, 14.8 gigawatts were owned by about 10,000 industrial and manufacturing units that had to generate power because the PLN supplies were not available at their location or were not reliable. Reliance on own means of generation is not easy, especially, for SMEs and commercial and residential consumers. 33 Reserve margin is one of the measures of power system reliability, i.e., the amount of unused available capability of an electric power system at peak load for a utility system as a percentage of total capability. 34 Losses were borne by the government. 54

73 Table 24: Power Supply and Demand Installed Capacity (MW) 24,840 25,890 28,916 29,545 29,988 (annual growth in %) PLN s Capacity 21,470 22,515 24,847 25,223 25,571 (annual growth in %) IPP s Capacity 3,370 3,370 4,059 4,320 4,416 (annual growth in %) Maximum Demand (MW) 18,896 19,263 20,354 21,306 21,866 (annual growth in %) Reserve Margin (%) Source: PLN, 2009 Regionally, Indonesia has the lowest industrial tariff for electricity, due largely to heavily subsidized electricity (below operational costs). This has discouraged the state-owned provider PLN to increase capacity (the more electricity it produces and sells, the greater are its losses). This is compounded by the fact that its T&D losses of 10 percent are higher, when compared to 7.2 percent in Malaysia and 7.3 percent in Thailand, while it is comparable to Vietnam and the Philippines. It is, therefore, not surprising that Indonesia s electrification rate (66 percent) is significantly lower than Thailand (99 percent), Malaysia (98 percent), Vietnam (97 percent) and the Philippines (79 percent) (Table 25). Table 25: Comparison of Electricity Indicators, 2009 Electrification Ratio (% of households) Transmission and Distribution Losses (%) a Residential Tariff (US$/kWh) Industrial Tariff (US$/kWh) Indonesia Thailand Malaysia Vietnam a a Philippines 79 a Source: a ) ADB, 2005; Companies websites, 2009 Key Constraints to Public Investment in Electricity Infrastructure Land Acquisition: In order to build power plants, set up transmission and distribution lines, land needs to be purchased. In instances where this is owned by the private sector, PLN will have to negotiate directly with the landowner and buy the land. If the land owner is asking for exorbitant prices, the legal process to acquire the land is long and protracted, resulting in PLN paying a premium for the land. Although there is legislation in place to expedite land acquisition, the government appears unwilling to implement and take unpopular decisions. Hence, acquiring land to establish new infrastructure is one of the major constraints to further investment in the sector. 55

74 Social Electricity Tariff-Setting of Below Cost Recovery: Nationwide uniform tariff has hampered the expansion of electricity production capacity due to profitability and sustainability concerns. This unsustainable phenomenon is adversely impacting on PLNs ability to invest in new power generation capacity. Generating and selling more electricity increases its operating losses, therefore, there is a strong disincentive for PLN to undertake further investment in the sector. In addition, social tariff-setting makes the sector inefficient, since there are no price signals for investors, indicating the lack of supply opportunity or for consumers to conserve energy. It is apparent that unless prices are economically viable, the target of 90 percent electrification by 2020 will become extremely costly and unsustainable for PLN and the government. Given the sensitivity of electricity pricing, it will require political courage and a revision of the subsidy schemes to ensure that both social and economic objectives are accommodated. Lack of Policy/ Regulatory Coordination: A World Bank study on rural electrification in Indonesia, Access for All, has found that there are many players in the country working on various rural electrifications programs (e.g., central government, local governments, PLN, NGOs, cooperatives) with government departments (MEMR, Ministry of Cooperatives Development, Ministry for the Development of Underdeveloped Area) with different agendas, procedures and financing sources. Unfortunately, there is no effective coordination among the different players. There are also legal and regulatory ambiguities surrounding the responsibility for rural electrification. It is unclear whether the responsibility is given to the Social Electrification Unit within MEMR or to the PLN. As a result, PLN disbanded their Rural Electrification Unit in 2001, and the rate of expansion was reduced further. This lack of a coordinated and holistic approach results in uncertainty on roles and responsibilities, lack of accountability, and duplication of efforts. Although coordination is theoretically a simple issue to address, it requires a concerted effort at all levels of government along with the ability to effectively delegate authority and implement decisions. Inefficient Allocation of Limited Resources: The decision to maintain oil price subsidies compounds the problem, hampers other energy programs, and remains a barrier to energy diversification and conservation. The subsidies have made it less viable to explore investment in alternative sources of energy. Such subsidies have created economic inefficiencies and have diverted limited state resources away from the provision of other important social and physical 56

75 infrastructure. In 2009, approximately 4 percent of GDP was allocated for fuel subsidies. Approximately half of this (2 percent) went to electricity sector (Figure 18). It must be noted that this is higher than the investment made in the electricity sector (less than 1 percent of GDP per annum during ). (IDR Trillion) Figure 18: Oil and Electricity Subsidies in Indonesia (forecast) (% of GDP) Fuel Subsidy (trillion IDR) Fuel Subsidy (percent of GDP) Source: Ministry of Finance, Electricity Subsidy (trillion IDR) Electricity Subsidy (percent of GDP) Resource Constraints: Part of PLN s electricity generation business is dependent on natural gas supplies. PLN has experienced difficulty in the past in obtaining adequate supplies of natural gas to meet its demand due to supplier s inability to deliver contracted volumes. Since 2003, it has faced a shortage of natural gas supply, which resulted in shutting down certain power plants and switching to fuel for some dual-fired plants. In addition, a 57

76 number of the natural gas fields from which PLN currently receive supplies is being depleted. Since supply agreements are medium-term (around five years), PLN, if required, could switch to other energy sources or alternative suppliers of natural gas. However, there may be delays in implementing such changes. In that case, natural gas will have to be procured from suppliers at greater distances. PLN continually negotiates with additional suppliers and is expanding its generation network to reduce its dependence on natural gas. But there is no guarantee that PLN will be able to establish or maintain the necessary infrastructure and supply contracts to secure sufficient additional gas supplies for its existing plants, or to implement its growth strategy. Part of PLN s electricity generation is dependent on coal suppliers. In order to increase the number of power plants, a stable supply of coal at reasonable prices must be secured 35. Indonesia has an abundance of coal reserves. Securing long-term suppliers at competitive prices will allow it to expand capacity, and establish new coal-fired power plants, with lower generation costs. Low Load Factor: The average power system load factor in Indonesia in 2007 was approximately 59.6 percent. This varies significantly between regions, ranging from 30 percent in Central Java to 84 percent in Riau (eastern part of Sumatera). This low load factor has made it difficult for PLN to expand its base load generation capacity. Due to the vast land area and several islands, it is not a viable option to develop a national grid. Private Investment and PPP in Electricity Infrastructure Independent Power Producers (IPPs) have been in operation in Indonesia since 1994 when licenses were issued to IPPs to generate electricity to be sold to PLN. As of 2009, IPPs contribute approximately 15 percent (4,568 MW) of the total capacity. Currently, there are 20 IPPs at the operational stage; 16 under construction; 30 at the financing stage, and 6 at the final stage of PPAs (Annex Table 3). Under these circumstances, it is important that all outstanding matters on 30 projects in the financing stage be resolved expeditiously so that generation capacity can improve substantially. IPPs in Indonesia are grouped into several categories depending on the project timing, type of power purchase agreement (PPA), or method of contract award: First generation IPPs: These are the first 27 IPPs that started operations in 1990s and whose PPAs were renegotiated by PLN due to the financial crisis in Under the Fast Track Program, PLN would need to build 33 coal-fired power plants 36 The renegotiations were a complex and protracted exercise with successful outcome for 58

77 Direct appointment of IPPs by PLN: According to the Government Regulation 3/2005, Article 11, para (6), the IPP contract could be awarded through direct appointment by PLN in instances where the IPP is: (i) operating either a coal mine, renewable energy resources or marginal gas resources; (ii) conducting capacity expansion to the existing project; and (iii) being developed in electricity-crisis area. Partnerships IPP: Small- and medium-sized IPPs in which PLN has equity interest in the project company. Infrastructure IPP: These IPP projects were announced in Infrastructure Summit in 2005 and 2006, in which the government and PLN are committed to implement the projects under the public-private partnerships (PPP) scheme as stipulated in the Presidential Regulation 67/2005. The second-generation PPAs usually refer to those negotiated and signed after the Asian financial crisis. They contain limited termination clauses for the benefit of the IPPs (for example, as the result of a default by PLN or force majeure, PLN--(not the IPP-- will be exposed to liabilities arising out of the contracts). However, second-generation PPAs have not been successful in the last few years. The primary causes for delay in the effectiveness of PPA include poor screening of prospective developers and the lack of government guarantees within the project structure. The success rate of the secondgeneration PPAs is only about 14 percent, leaving many IPPs dormant, failing to achieve financial closing (Table 26). Table 26: Types of Power Purchase Agreements (PPA) PPA % Financed IRR s Offered Note (estimate) First generation PPA 59% (15 out of 20-25% Generic government guarantee 29) Second generation PPA 14% 12-14% No government guarantee Third generation PPA % Revenue guarantee Source: PLN, 2009 PLN is now working on the third-generation PPAs, with a well-defined risk allocation to facilitate project bankability. They refer to the model PPA based on the PPP regulation, which includes the provision of government support to the IPP projects. In the third-generation PPA, the government provides PLN. Of the 27 IPPs totaling 11,300 MW, 14 contracts for 5,690 MW were continued under renegotiated terms, 6 contracts for 4,490 MW were terminated, 6 contracts for 900 MW were acquired by the Government and PLN, and only 1 contract for 220 MW ended in legal dispute not involving PLN 59

78 revenue guarantee to IPPs, and takes the responsibility of the regulatory and political risks. However, the PLN is currently developing a third-generation PPA as a model involving all the stakeholders. Main provision of electricity laws are summarized in Box 5. As previously stated, the long-term sustainability of PLN is questionable due to the fiscal burden of the subsidies. It thus poses a credit risk for foreign investors, with the resultant effect of potential investors seeking government guarantees to underwrite PLN s obligations under the PPA. If this is viewed in the context of government debt, which is currently in excess of 130 percent of GDP, the long-term viability and certainty for investors becomes even more uncertain. The government and PLN will have to work out the appropriate form of performance guarantees to overcome the perceived country and sustainability risks associated with the IPP projects. A priority area would, therefore, be to minimize future contingent liabilities by appropriately sharing risks between the government and the private sector. The vulnerability to macroeconomic shocks and the drawbacks of corruption and a weak judicial system (see analysis on the growth diagnostic framework) do not make Indonesia an attractive destination for investors in the electricity sector, particularly in today s challenging economic environment. In order to play a more catalytic role, PLN will need to structure and supervise a fair, open and competitive process. In particular, it should pay attention to: providing required guarantees to the lenders to make the financing viable; preparing bankable projects with the assistance of experienced lawyers and transaction advisors, ensuring risks are appropriately allocated to entities best positioned to absorb them; and identifying/ structuring potential local currency and force-majeure event solutions in the contractual framework. To address these concerns, PLN would need to develop a model IPP project that would be a showcase for successful implementation of bankable IPP project, which is structured and executed in accordance with the international best practices. Key Constraints to Private Investment and PPP in Electricity Infrastructure Land Acquisition Problem: As previously stated, the acquisition of land for development projects remains one of the major constraints to new 60

79 Box 5: One Step Forward, Two Steps Backward Second Time Around? Electricity Law No. 20 of 2002 was intended to reform the electricity subsector and encourage private investment in it by introducing market competition; unbundling Perusahaan Listrik Negara (PLN), the state electricity agency; establishing a regulatory agency; increasing the role of regional governments in provision of social electricity and price setting to noncompetitive regions; and encourage private sector participation in the sector. The law was a breakthrough and its implementation would have brought Indonesia to par with other countries in the region that had initiated similar reforms. The law, however, was annulled by the Constitutional Court of Indonesia in December 2004 on the grounds that it was not in line with Article 33 of the Indonesian Constitution of 1945, which states that sectors of production which are important for the county and affect the lives of the people shall be controlled by the state. The court interpreted the term control as to regulate, facilitate, and operate such facilities. The court decision was a major blow to the reforms in the subsector and the possibility of private sector participation. Annulment of the law meant that the country had reverted to Electricity Law 15 of The court decision implied that private ownership of electricity was not in the people s best interest and the efficiency gains envisaged through unbundling the industry into seven proposed areas (generation, transmission, distribution, market operator, system operator, retail and wholesale) were not to be achieved. To formulate and enact a new law took nearly 5 years from the court decision and 8 years since passage of the 2002 law. The Indonesian Parliament passed the Electricity Law of 2009 (Law 30/2009) on 9 September The new law, although not as ambitious as the 2002 law, introduces changes that would allow entities other than PLN to participate in electricity supply and aims to redefine PLN s roles and mandates. The law s implementing rules and regulations, however, are yet to be issued. Due to opposition from different sections, especially within PLN, there are fears that a long time may pass before the intent of the law can be put into action. There are also concerns that the new law could also be struck down in court. The country has already lost 8 years by not implementing the 2002 law and the losses from the delay must be monumental in economic terms. Hopefully, any interventions by the Constitutional Court, if warranted, will work in favor of the general public s welfare. Main Provisions of Indonesia s Electricity Laws Electricity Law 15/1985 The Government of Indonesia is responsible for regulating the electricity sector. Private companies are allowed to participate in the electricity business, however, Perusahaan Listrik Negara is the single buyer of electricity and controls both transmission and distribution functions. Electricity Law 20/2002 The law established a competitive electricity market through multiple power generators and by restructuring and unbundling Perusahaan Listrik Negara s functions. The law also provided the mechanism for adjusting electricity tariffs, rationalized the mechanism for power purchase for the private sector and established a regulatory mechanism for the sector. Electricity Law 30/2009 Perusahaan Listrik Negara will no longer have the monopoly on supplying and distributing to end customers. Independent power producers will be allowed these functions, particularly in the regions, however, subject to a right of first priority provided to Perusahaan Listrik Negara. Sources: World Bank, 2005; ALB Business News, downloaded 13 May 2010., Purra, Mika The Indonesian Electricity Sector: Institutional Transition, Regulatory Capacity and Outcomes, National University of Singapore, Singapore. 61

80 Box 6: Model Power Purchase Agreement (PPA) PLN is developing a third generation PPA, which would become a model PPA based on the PPP Presidential Regulation 67/2005. Consultation has been conducted with investors and potential lenders that include the export credit agency (ECA), multilateral, bilateral, and commercial banks. While the provisions of the model PPAs are still being finalized, some of the highlights are provided below: Government Force Majeure (GFM) Events: Standard market practice is such that the risks are allocated to government-related off taker. Attempts to limit the off taker risk for government force majeure events have significantly reduced international financing (JBIC, 2009). As a state-owned monopoly, PLN is perceived to be in the best position to bear the GFM risk. It is essential that PLN is appropriately supported by the government through its guarantee of support letter. Revocation of the government guarantee should constitute an event/force majeure and/or termination of agreement. Changes of Law: For IPP projects, changes in law that have a financial impact on the project should be covered by PLN and the government, by allowing tariff adjustments. Responsibility for Site Acquisition: Acquisition of land is fundamental component of IPP projects. The host government is in the best position to acquire land for the IPP projects. Private acquisition can lead to delays in the development of infrastructure projects if landowners refuse to sell at reasonable prices. Take-or-Pay Clause: If the power plant is available and ready to supply power, the off taker is obligated to pay capacity payment regardless of whether the off taker is willing or able to take the electricity. Inclusion of a grace period in case of deemed dispatch is contrary to the fundamental take-or-pay contract. Fuel Supply Arrangements: The project company should only be required to take fuel supply risk to the extent within its control. If the project company is required to take the fuel supply risk, it should be given flexibility to mitigate and manage such risks. If PLN requires approval rights over the price or other terms of replacement fuel supply agreements, deemed dispatch or other suitable measure (e.g., PLN delivering the coal on the same terms) should apply if such approval is withheld. Termination Payment: It should cover not only the outstanding loans but also interest rate hedging and other customary financing unwind costs. Provision of Government Guarantees: Presidential Regulation 67/2005 is the cornerstone of the new PSP framework that aims at establishing a clear and predictable environment within which private investors will operate. Under this regulation, PPP projects can be identified and prepared either by the government or the private sector. However, the sponsors must be selected through open and transparent bidding. It provides details on the nature of the PPP agreements, the rules and procedures for the bidding process, and calls for tariffs to be set at full cost recovery. If this exceeds the affordability of consumers to pay, the government must compensate for the difference with a PSO subsidy. In addition, it recommends that risks be allocated to the party that is best able to manage and control them. In this regard, the Minister of Finance issued MOF Regulation 38/2006 to ensure that risks of individual PPP projects are appropriately allocated between the public and private sectors, and that the government s overall exposure is appropriately managed. Regulation 38/2006 also describes the types of risks the government may consider sharing (those related to political events, project performance, and demand), the main principles for providing such support (legality, project quality in terms of technical and financial feasibility, fiscal prudence in terms of total exposure and annual budget, and transparency), and approval procedures. 62

81 investment in the sector. In instances where a project is private sector-driven, the responsibility for resolving the land acquisition issue rests solely with the private sector. In many instances, they are forced to pay premium prices or risk long delays in acquiring land. This adversely impacts on project timing, planning, costs and operationalization. PPA Pricing Below Cost of Supply: Pricing of electricity for purchase by PLN from private power producers has been one of the most significant barriers to IPPs, especially those based on renewable energy resources. PLN was required to purchase electricity based on a formula that used the nationwide uniform tariff (TDL) as a reference. This regulation has resulted in small and renewable PPAs being unviable, since prices do not truly reflect the cost of supply. New reference prices based on local cost of supply were recently introduced (November 2009) to overcome this problem. Revising a signed PPA owned by existing IPPs (but yet to achieve financial closing) would require inter-ministerial coordination and strong leadership within the government. The PPAs would be renegotiated for price increase and new provision of the government support (Box 6 & Box 7). Lack of Government Support and Risk-sharing Structure of IPP Projects. The lack of government support has caused several IPP projects to fail in achieving financial closure. The effective risk-sharing mechanism should be based on the principles that risk should be allocated to the party that is in the best position Box 7: Renegotiation of PPAs (prices and government support) Renegotiation of PPA prices in Indonesia was conducted during the period of when the government, through the Presidential Decree 133/1999, negotiated PPA prices considered too high due to the Asian economic crisis. Currently, renegotiation of PPA prices are being requested by the IPP developers (who have failed to achieve financial closure) to increase the PPA price. While the exact form of the Presidential decree itself is still being discussed, the highlights are provided below: Inter-ministerial PPA Renegotiation Team consisting of the related ministers, under the leadership of the Coordinating Minister for Economic Affairs, deciding on either accepting or rejecting the result of PPA renegotiation conducted by renegotiation working group. Technical Committee -It consists of Deputy Ministers/Directors General from the related ministries, and representative from PLN (the CEO) providing recommendations to the Inter- Ministerial Team. Renegotiation Working Group-Executive level working group established by the Inter- Ministerial Team to plan and conduct the renegotiation strategy, and report the result of the renegotiation to the Team for decision. PLN is said to formulating a list of about 50 IPPs that have failed to achieve financial closure for renegotiation. 63

82 Figure 19: IPP Procurement Process Ministry of Energy and Mineral Resources (MEMR) Regulation No.1/2006 and 4/2007 Project Tender Announcement 27 days 57 days 104 days 154 days 50 days 90 days Prequalification of Bidders (PQ) Issuance of Request for Proposal (RFP) and Acceptance of Bids Bids Evaluation and Contract Award For Capacity < 15 MW: 196 days For Capacity > 15 MW: 321 hari 10 days 10 days Contract Negotiation Winning Bidder Request for Temporary Business License to MEMR 10 days 10 days Corporate Approval PPA Price Approval by MEMR 5 days 10 days Signing of Power Purchase Agreement (PPA) to address and mitigate them. The GOI is best suited to manage risks related to the country, political, and/or government actions/events, while the distributor is most suited to carry risks related to electricity network operation (including demand/supply risk, grid failure). Private investors and lenders, on the other hand, should bear risks related to construction, operation, and maintenance of IPPs. By offering an appropriate and conservative risk-sharing structure, the government and PLN would be in a better position to promote tariff competition among private investors in the sector and encourage investment within a stable and consistent framework. There are also significant delays in IPP procurement process (Figure 19). Table 27: Summary of Major and Minor Constraints to Electricity Infrastructure Constraints Major/Minor Constraints Land Acquisition problem Social Electricity Tariff-setting Below Cost Recovery Lack of Policy/Regulatory Coordination Inefficient Allocation of Limited Resources Lack of Financing Poor Governance PPA Pricing Policy Low Load Factor Lack of Government Support and Risk-sharing Structure of IPP Projects Key: : Major Constraint : Minor Constraint The above analysis highlights key constraints hampering investment in electricity infrastructure. These include land acquisition problem; lack of 64

83 policy/ regulatory coordination; inefficient allocation of limited resources; lack of financing; PPP pricing policy below cost of supply; low load factor; and lack of government support and risk-sharing structure of IPPs (Table 27). vi) Telecommunications The telecommunications sector is currently dominated by three large players (e.g., Telkom, Indosat, and Excelcomindo), with strong barriers to entry for others. It is, therefore, not surprising that affordable access to telecommunications and internet infrastructure is limited. Overview of Telecommunications Sector The importance of telecommunications sector to economic development is widely acknowledged. Wellenius et. al. (1994) showed that along with labor and capital, telecommunications is a fundamental factor of production 37. They emphasized that telecommunications facilitates market entry, reduces costs, improves customer services, and increases productivity. It is, therefore, encouraging to note that telecommunications infrastructure in Indonesia was not identified as a major constraint to economic growth. In a recent economic survey conducted by OECD 38 in 2008, only 21 percent of the firms surveyed reported availability of telecommunications as a business constraint, compared to 49 percent for transport and 43 percent for electricity infrastructures. However, compared to other Asian countries, telecommunications infrastructure in Indonesia is still lagging far behind. This is evident by the: low level of teledensity (driven by underinvestment and unequal distribution of telecommunications infrastructure); low internet penetration; lack of competition in fixed-line telecommunication business; and lack of consistent and independent regulations on telephony and internet services. The fixed-line telecommunications infrastructure exhibited double digit annual growth between 1970 and However, between 1999 and 2002, the growth dropped to below 5 percent per year, largely because of the Asian financial crisis. It, however, rose to around 11 percent in In 2007, despite the introduction of cellular communications, the growth in fixed-lines remained robust, with the total number of subscribers amounting to 17.8 million. 37 Wellenius, B. Telecommunications, World Bank Experience and Strategy, Washington, OECD Economic Surveys, Indonesia Economic Assessment,

84 The Indonesian mobile market enjoyed explosive growth of 45.3 percent per annum between 2002 and 2007, much higher compared to Malaysia (18.4 percent) and the Philippines (24.7 percent), but comparable to Thailand and Vietnam. Similarly, the growth of fixed-line telephones was 16.3 percent per annum, which far exceeded that of Malaysia, the Philippines and Thailand over the same period (Table 28). Table 28: Teledensities (number of connections per 100 inhabitants) in Indonesia Fixed Line Mobile CAGR (%) CAGR (%) Indonesia Malaysia Philippines Thailand Vietnam Source: ITU, Public Sector Investment in Telecom Infrastructure In 1985, Telkom, as a public service agency, was corporatized as a stateowned company. Since then, government budget is no longer utilized in the development of telecommunications physical infrastructure. The government, in consultation with industry stakeholders, is more focused on how to leverage the telecommunication infrastructure for the development of other public sectors. In 2006, the government established National Council for Information and Communication Technology (DeTIKNas), which developed the following seven national programs: e-education: ICT network for educational purpose connecting 24,802 education offices, schools, and universities all over Indonesia; e-procurement: online, transparent, and efficient ICT-based public procurement system for government institutions both at central and regional levels; e-palapa Ring: fiber optics network connecting all provinces in Indonesia; National Identity Number (NIN): the use of single ID number for citizens to assist with the provision of public services; e-budget: online and efficient national state budget system for government institutions, both at central and regional levels; National Single Window (NSW): an integrated, real-time system for export-import management; Use of legal software: compliance to the intellectual property law on the use of legal software. 66

85 The implementation of these public sector projects is funded by the national state budget, bilateral/multilateral loans, or through the public-private partnerships mechanism. The Ministry of Communication and Informatics (MCI) is responsible for the implementation of public investment in the ICT sector. Two outstanding ICT projects under the MCI purview, which are funded by the Japanese and Spanish Governments (i.e., ICT Utilization Project for Education Quality Enhancement in DIY Province Project and Improvement of TV Transmitting Station Project), unfortunately, have not been able to take off due to delay in loan administration. Key Constraints to Public Sector Investment in Telecom Infrastructure On the basis of the above, initial attempts at PPPs in the telecommunications were unsustainable due to: Lack of Bankability of Projects: A substantial proportion of projects in the telecommunications sector that is available for PPPs is based in rural areas. The cost of rolling out projects in these areas is high, while telecommunication tariff for fixed-lines is not set independently by the regulator, but rather through socio-political considerations. In this regard, rural tariffs will have to be in line with national tariffs, and not higher due to the additional infrastructure costs. This discourages investors from developing new subscriber network, including the implementation of the universal service obligations (USO) projects. In addition, the maintenance of completed USO networks is problematic, since the tariff barely covers operational and maintenance costs. This could be addressed either by subsidization (not a good alternative due to its fiscal impact) or, by increasing the local fixed-wire line tariffs. However, historically the government refused to accede to raising telephone call tariffs in 2006 due to what it considered unfavorable socio-economic conditions. Weak Human and Institutional Capacity: This is best illustrated by the examination of the USO and Palapa Ring Projects. In the case of the USO projects, the call for tenders failed to attract sufficient qualified bidders in This was probably due to the inability to prepare attractive bankable projects that would attract quality bidders. This necessitated a repetition of the tender process a year later. In the case of Palapa Ring Project, due to transparency concerns in the selection of members of the project consortium, some members decided to leave the consortium. The funding commitment from the remaining three members (Telkom, Indosat, and Bakrie Telecom) was insufficient to cover the project costs, with government having to allocate some budget to finance the project. 67

86 Private Investment in Telecom Infrastructure Apart from selling more Telkom and Indosat shares on the international and domestic capital markets, private sector investment in the telecommunication sector has been encouraged through the reduction of monopoly of Telkom and the auctions of various licenses to private sector operators, e.g.,: issuance of IDD license to Bakrie Telecom in 2009; tendering-out of USO concession since 2007; issuance of voice-over-ip (VoIP) licenses to 5 operators since 2003; issuance of broadband wireless licenses to over 20 operators since 2003; and issuance of CDMA and GSM DCS 1800 licenses to 4 private operators since This has resulted in increased private sector participation, particularly in the cellular telecommunications. Given some of the concerns raised earlier, it is not surprising that the largest interest (number of operators) was in the cellular market (Table 29). Recent analysis by Credit Suisse (2008) 39 asserted that price competition and the combination of high capex (for coverage and capacity), together with lowerthan-expected revenues, translates into lower industry return-on-investedcapital (ROIC) for Indonesia s telecommunications industry, estimated at only 6 percent in 2010, down from the initial projection of 8.4 percent. This is below the cost of capital for the telecoms industry, and is significantly lower than the current country risk-free rate (the yield of local currency government bonds in early October 2009 was approximately 10 percent). The Anti-Monopoly Commission (KPPU) has attempted to maintain fair competition in the telecommunications sector, when, since 2006, it has started to monitor abuse of market power by the dominant players that could marginalize smaller telecom operators and derail the growth of the telecom industry. In 2007, KPPU made a landmark decision when it ruled that Temasek had contravened competitive guidelines given its large shareholdings in both Telkom and Indosat, and was instructed to divest its stake in either of the two companies within 12 months. Following a protracted court battle during which Temasek had rigorously defended its position, QTel (of Qatar) finally announced in June 2008 that it will acquire 40.8 percent stake held by Temasek in Indosat (by November 2009 QTel owned about 65 percent of Indosat). 39 Credit Suisse, Indonesia Telecom Sector, August

87 No Table 29: Operator of Telecommunication Services in Indonesia Operator Fixed Wire line Fixed- Wireless CDMA Mobile Cellular CDMA Mobile Cellular GSM 1 Telekomunikasi Indonesia (includes Yes Yes Yes Telkom and Flexi) 2 Indosat (Indosat) Yes Yes Yes Yes 3 Bakrie Telcom (Esia) Yes Yes 4 Batam Bintan Telekomunikasi Yes 5 Telekomunikasi Seluler (Telkomsel) Yes 6 Excelcomindo Pratama, Tbk. (XL) Yes 7 Natrindo Telepon Seluler (Axis) Yes 8 Hutchison CP Telecommunications Yes Indonesia (3) 9 Sampoema Telekomunikasi Indonesia (Ceria) Yes 10 Mobile-8 Telecom. Tbk. (Hepi. Fren) Yes Yes 11 Smart Telecom-Sinar Mas Group Yes (Smart) Source: Director General Post and Telecommunications, 2008 It has been observed that two further changes to the regulatory framework could provide added concerns for private investment in the Indonesian wireless sector, with complicating effects. The two recent regulatory cases are: the directive issued by the Minister of Trade, prohibiting the ownership of telecommunication towers by foreign entities, which goes against the spirit of foreign direct investment flows into the country and the sector; and the directive of sharing telecommunication towers that would help bring down the cost of network deployment for new entrants, while charging a significant assets write-off for the incumbent operators. Public-Private Partnership in Telecommunications Although Telkom was corporatized in 1985, public-private partnerships in the sector commenced 10 years later in This followed an international competitive bidding process to accelerate investment and expansion of local telephone networks on a build-operate-transfer (BOT) basis (known as Joint Operating Services or KSOs) between Telkom and private investors. The KSOs were obliged to install around two million lines, granted control over existing Telkom assets, and assumed all commercial risks, in return for revenuesharing with Telkom based on a pre-defined formula. The financial crisis adversely impacted on the implementation of the KSO scheme, and forced IDD 69

88 Telkom to renegotiate the KSO contracts to ensure their financial viability. This resulted in fewer line build-out obligations, reduced revenue progress on the planned tariff increase, international arbitration and buy-out discussions emerged between Telkom and the KSOs. Currently, only one KSO (Bukaka Telekomindo Internasional) remains, while four others (West Java, Central Java, Sumatra, and Kalimantan) were bought out by Telkom (Box 8). An evaluation of the failure of the KSO scheme indicates a typical currency mismatch risk between Indonesia rupiah-based revenue-sharing and US dollar based-capital investment that emerged with the onset of the Asian financial crisis in the late 1990s. Efforts to increase telephony tariff, as agreed during the KSO renegotiation to compensate for the loss of revenue, were not effective since the tariff was still closely regulated by the government and heavily politicized. Another use of PPP in the ICT sector is in the implementation of USO projects. In July 2005, the GOI implemented the Universal Service Obligation (USO), which requires telecommunications operators to allocate 0.75 percent of their revenues for USO funds. These funds are paid to government for supporting the development, operation and maintenance of telecommunications service (telephony and internet access) in underdeveloped areas (e.g., remote villages, rural areas, border areas etc). USO projects will be licensed to private sector operators who would use the USO fund to build and operate the telecommunication network on a profit-sharing basis. The USO project arrangement is similar to the previous KSO schemes in late 1990s. However, the tender process for the USO projects did not materialize until 2007, when no winning bidder was selected due to bid disputes involving claims on the inadequate qualifications of the tenders. The USO projects for telephony services were re-tendered in early 2009, with Telkomsel and Indonesia Comnet Plus being awarded the tenders. Key Constraints to Private Investment and PPP For private sector investment in telecommunications, the following two issues emerge as the most important: Monopolist Environment: The dominance by the state-owned Telkom has discouraged competition and investment in telecommunications sector. The anti-competitive behavior of Telkom (e.g., restricting interconnection to Telkom s network) has made inter-operator telecommunication expensive for consumers. Interconnection charges were negotiated bilaterally between operators and Telkom, and there is no standard reference (contract terms and pricing). This has produced anti-competitive practices that are both discriminatory and lack transparency. There has been an allegation that 70

89 Box 8: Joint Operation Service (KSO) Five private companies were awarded 15-year government contracts in 1994 to work with PT Telkom in the expansion of the national network, each in a separate geographic area. These Build-Operate-Transfer (BOT) agreements, set out to provide two million phone lines by Under the KSO, each consortium was granted a concession to build and operate a fixed-line network in the nominated zone on behalf of PT Telkom. The licenses contained certain Universal Service Obligations (USO), which required the companies to commit 20 percent of their investment into the rural areas. The overall objective of the program was to increase the national network to achieve a ratio of 20 lines per 100 people by the year Operations of the designated regions were transferred to the private operators in January However, three of the consortia failed to reach their targets by December Telstra s Central Java network was among those under investigation from PT Telkom. The government contracted AriaWest International to attempt to speed up installations in Java. The problems continued when only 130,000 lines out of the target of 400,000 lines (for 1997) were installed. The Asian Economic Crisis of 1997/98 that resulted in a significant depreciation of the Indonesian rupiah against US dollar, ultimately forced a substantial renegotiation of the KSO agreements. In 1998, PT Telkom agreed to a package of measures to alleviate some of the KSO s problems, including: reducing the combined line roll-out target to 1.3 million from 2 million by March 1999; increasing the KSOs share of telephone service revenues from 70 percent to 90 percent; and waiving the buy-out option after 10 years of the 15-year franchises. All five KSOs subsequently managed to achieve their individual revised March 1999 targets, with a total of 1.39 million new lines being put in service by that time. The disputes over the KSO agreements, however, continued beyond the negotiations that were completed in 1998, with the government being forced to step in and act as a mediator in the ongoing problems. Telkom bought out one of the private companies, PT Daya Mitra Telekomunikasi (Dayamitra) for $122 million in the Kalimantan Zone. In May 2001, Indosat bought out the shares in one of the KSOs, PT Mitra Global Telekomunikasi Indonesia (MGTI), for $1.5 billion. The company wanted to revise the original agreement it had with Telkom and establish a new agreement with clearer and more definite commercial arrangements, particularly in relation to infrastructure and profit sharing. MGTI was 32.5 percent owned by PT Widya Duta Infotel, 30 percent by Indosat, 2 percent by Australia s Telstra Global Ltd and 15 percent by NTT Finance Ltd, while two Japanese investors have minor stakes. By March 2001, MGTI had invested about $480 million in telecommunications networks in Central Java. In 2004, Telkom entered into an agreement with MGTI to amend the original KSO Agreement. Under the amended KSO Agreement, which would still run until 2010, MGTI s operating area would be operated under the management and supervision control of Telkom. The new agreement allowed Telkom to invest in the region at its discretion. MGTI was to receive a fixed monthly payment drawn from revenue, ranging from $5.4 million per month in 2004 to $6.8 million per month in In July 2001, Telkom unilaterally terminated its joint operation contract with AriaWest International. The move by Telkom followed earlier action by AT&T in which it had filed international arbitration proceedings with the International Chamber of Commerce in Paris in May 2001, demanding $1.3 billion in compensation from PT Telkom for losses allegedly incurred. In November 2001, PT Telkom also took legal action claiming that it had suffered losses as a result of AriaWest s non-performance. In May 2002, Telkom announced that it had signed an agreement to buy out PT AriaWest for $363 million, and the pending arbitration action was brought to an end. The deal included Telkom taking over AriaWest s debt obligations, and completed in In April 2002, PT Telkom reached a sale and purchase agreement on France Telecom s 40 percent stake in PT Pramindo Ikat Nusantara for a price of $425 million. PT Pramindo had been Telkom s KSO partner in Sumatera. In August 2002, Telkom took over the operation and assume the debt of Pramindo, including the $86.2 million debt to the International Finance Corporation (IFC). SingTel was reported in October 2005 to be in talks to sell its stake in the fixed-line network in eastern Indonesia to PT Telkom. Indonesian partner Bukaka Telekomindo owns the remainder of this joint venture. The only remaining KSO that was not under the ownership control of Telkom was Bukaka, covering the Eastern Indonesian Islands from Sulawesi to the Mollucas and Papua. Under the KSO agreement, termination of the KSO VII concession will occur in 2010, at which time Telkom is expected to gain ownership rights to all of the assets of this last remaining KSO. SingTel sold its entire stake in Bukaka SingTel International during 2006 for IDR532 billion ($58.5 million) to Bukaka Telekomindo International. 71

90 interconnection fee charged by Telkom to Telkomsel (Telkom s cellular subsidiary) may be lower than those to other cellular operators 40. The dominance of Telkom in the fixed-line access has also affected business of competitors, such as Indosat. For instance, Indosat preferred to enter into a revenue-sharing mechanism with its potential business partners rather than incur direct capital and operating expenses for its fixed-line network expansion. This is not an attractive investment, and thus Indosat s fixed-line business portfolio remains small, below 9 percent of its total revenue. Weak Legal and Regulatory Environment: The Telecommunications and Informatics Regulatory Agency (BRTI) is chaired by the Director General of Post and Telecommunication of the Ministry of Communication and Informatics (MCI). Although it is well established comprising of knowledgeable and experienced commissioners, it does not have the authority to issue its own directives/regulations. BRTI s regulatory jurisdiction is limited to network provider and basic telecommunication services, while value-added services like VoIP and other multimedia services are still regulated by MCI. This has resulted in its becoming somewhat ineffective, especially in terms of the legal and regulatory framework. In this regard, the institutional set-up of BRTI, including its authority and jurisdiction, is currently being examined with a view to making it a strong and independent regulatory body that complies with international best practice. An example of the weak legal and regulatory environment can be cited in the case of Indosat s international direct dialling (IDD) (Box 9). Table 30: Summary of Major and Minor Constraints to Telecommunications Constraints Major/Minor Constraints Weak Regulatory Framework Weak Human and Institutional Capacity Lack of Bankability of Projects Poor Governance Monopolist Environment Difficult Land Acquisition Shortage of Long-term financing Key: : Major Constraint : Minor Constraint The above analysis highlights that the key constraints hampering new investment in telecommunications infrastructure include the lack of human and institutional capacity within the government; weak regulatory framework, 40 Rasyid, Asmiati, Indonesia: Liberalization at the Crossroad Impact on Sector Performance, Teledensidy, and Productivity, Communication and Strategies,

91 Box 9: Indosat s IDD The weak legal and regulatory environment is evident on examining the case of Indosat s international direct dialling (IDD) business, which directly connects Indonesia to more than 260 other countries and destinations worldwide. Indosat operates four international gateway exchanges in Jakarta, Medan, Batam and Surabaya. The Jakarta gateway serves the Jakarta metropolitan region and the West Java and Central Java provinces, accounting for approximately 64 percent of the company s international traffic. During 2001, IDD traffic dropped by 7.5 percent, and was attributed to the increased application of Voice over Internet Protocol (VoIP) for international calls. VoIP was estimated to have captured a 5-10 percent share of the international telephone market by end Although VoIP licenses were officially issued by the government to five operators (e.g., Telkom, Satelindo, Gaharu, Atlasat, and Indosat), there are several unlicensed VoIP operators that continue business. Despite the regulator attempt to eliminate illegal VoIP operators, the numbers kept increasing. In 2002, Indosat s IDD traffic dropped a further 20 percent and it claimed that illegal VoIP inflicted loss of about IDR 245 billion ($ 27 million) per year (Source: Gatra Akibat VOIP Illegal Indosat Rugi, January 19, 2009). Indosat s IDD business deteriorated further when, in 2004, Telkom received IDD license from the government and started offering a clear channel code IDD 007, in conjunction with its other products. Telkom claimed that it held a 52 percent share of the IDD services market at the end of April Currently, Indosat s IDD and fixed-line businesses accounts for only 9.7 percent of total revenue. (Source: Mandiri Sekuritas Debt Research, November 2009). lack of bankability of projects; and monopolist environment in the sector (Table 30). VI. CONSOLIDATION OF SURVEY RESULTS AND SUB-SECTORAL IN-DEPTH ANALYSIS On the basis of discussions held with stakeholders involved in infrastructure development from both the private and public sectors and the results of the primary survey (conducted between September 2009 and November 2009), the major and minor constraints to infrastructure investment are identified. It is worth reiterating that the study is not intended to provide a laundry list of constraints to be addressed in the medium- to long-term, but it rather focuses on the most (key) binding constraints that could be tackled over the shortto medium-term. The survey results suggest that most binding constraints hindering the pace of infrastructure development in Indonesia in order of severity are: i) difficulty in land acquisition; ii) weak human and institutional capacity; iii) poor governance; and iv) shortage of financing. 73

92 The survey also indicates that macroeconomic stability has been maintained and viewed positively by investors (i.e., not adversely impacting infrastructurerelated business). Further, on examining the improvement in various factors related to the overall business and investment climate for infrastructure development, the survey shows that there was little improvement on return on infrastructure investment during the last few years. An in-depth analysis of three major sub-sectors: (i) Transport (roads, railways, ports and airports); (ii) Electricity; and (iii) Communications was also undertaken to determine the constraints hampering investment in these subsectors. With regard to various components of the transport sector, difficulty in land acquisition appears to be the most binding constraint, followed by the weak institutional and human capacity within the government (which manifests itself in the inability to prepare bankable projects and implement government regulations); poor governance; and lack of long-term funding. The analysis highlights that the key constraints hampering new investment in railways infrastructure include lack of human and institutional capacity, in particular weak regulatory framework; problem of land acquisition; non-availability of long-term financing; and low return on investment. With regard to ports, the key constraints include: lack of institutional and human capacity, particularly the inability to prepare bankable projects; weak regulatory framework; poor governance (i.e., corruption/ rent-seeking activities); and low returns on investment. Finally, in the area of air transport, the constraints are: weak human and institutional capacity, in particular weak regulatory framework; poor governance; rare long-term funding including weak funding capacity for non-commercial airports; and low return on investment (Table 31). For the electricity sector, the key constraints hindering investment include: difficulty in land acquisition; lack of human and institutional capacity, in particular lack of policy/ regulatory coordination; lack of financing; social electricity tariff-setting of below cost recovery; and inefficient allocation of limited resources. With regard to the telecommunications sector, the key impediments include: lack of human and institutional capacity, particularly lack of bankability of projects and weak regulatory framework; and poor governance. However, land acquisition and long-term financing appear to be minor constraints because of the boom of cell phone industry mainly handled by the private sector (Table 31). On the basis of primary survey analysis, four major common constraints hindering investment in the sub-sectors of infrastructure (Transport, Electricity, and Telecommunication) have been identified. They are: (i) difficulty in land 74

93 acquisition; (ii) weak human and institutional capacity; (iii) poor governance; and (iv) shortage of financing 41 (Table 32). The underlying reasons for each of the major constraints are described in the following section. Table 31: Major Constraints to Infrastructure Development in Indonesia (Based on In-depth Analysis of Sub-sectors) Major Constraints Transport Road Railways Ports Air Electricity Telecom. Difficulty in Land Acquisition Weak Human and Institutional Capacity * Poor Governance Non-availability of Long-term Funding Perceived Low Return on Investment Social Electricity Tariff Setting of Below Cost Recovery Inefficient Allocation of Limited Resources : Major Constraint * In consistent with the survey definition, this factor is the underlying issue behind the negative perspective on several areas including: Government Coordination, Bankable Projects, Implementation Capacity, Interface with the Government, and Legal and Regulatory Framework. Table 32: Summary of Survey Constraints and Key Constraints to the Overall Infrastructure Sector in Indonesia Major Constraints Transport Electricity Communication (Based on Survey and In-depth analysis) Land Acquisition Problem Weak Human & Institutional Capacity Poor Governance Shortage of Financing Key: : Major Constraint : Minor Constraint Weak and inadequate infrastructure has not only adversely affected the Indonesian economy but also its connectivity with its neighbors, particularly Malaysia and Thailand (see sections I and V). This is underscored by the slow implementation of the Indonesia-Malaysia-Thailand Growth Triangle (IMT- GT) Initiative, which aims to accelerate private sector-led economic growth and help facilitate the development of the sub-region as a whole These constraints along with their prioritization were strongly re-validated by participants and speakers at the Infrastructure Asia 2010 Conference held in Jakarta, Indonesia on April Furthermore, key public and private sector stakeholders in the infrastructure sector corroborated the findings of this study. 42 This is a sub-regional cooperation initiative started in 1993 by the governments of Indonesia, 75

94 Since its formation in 1993, the IMT-GT has grown in geographic scope and activities. It has the potential of improving both intra-and inter-regional growth and equity. Strengthening cross-border transportation and logistics linkages would expand market size, as well as economic opportunities that could be exploited by the bordering provinces in each of the three countries. In turn, this would reduce disparities within each of the countries. The IMT GT has identified economic connectivity corridors that cover 10 provinces in Sumatera. To fully benefit from the IMT GT and the preferential trade access, Indonesia would need to boost investments in manufacturing and services in the 10 provinces. However, investment will be difficult to attract unless the transport networks and electricity supplies in the provinces can be significantly improved 43. In order to exploit its potential, an IMT-GT Roadmap was prepared with a strong infrastructure bias. In terms of population, land area and employment opportunities Indonesia stands to gain the most among the three countries. However, the country s infrastructure imbalances limit its ability to benefit from this important regional initiative. Needless to say, the constraints identified as part of this infrastructure diagnostic study also plague the IMT- GT (i.e., weak human and institutional capacity, coordination failures, and shortage of financing) (Box 10). VII. UNDERLYING REASONS FOR KEY CONSTRAINTS IDENTIFIED i) Difficulty in Land Acquisition From the perspective of investment in infrastructure, difficulty in land acquisition is arguably the most binding constraint inhibiting public and private investment, and public-private partnerships in transport, electricity and telecommunications. Given the vastness of Indonesia, the question is why the cost of land is so prohibitive? Speculative activity along with breach of confidentiality on development plans adversely impacts on financial viability of projects. Discussions with private investors revealed that a number of projects were delayed due to problems with land acquisition, especially in toll-road projects. There were instances Malaysia, and Thailand, with objectives of accelerating and sustaining economic growth, reducing poverty, improving the quality of life, and establishing peace and stability in the subregion through enhancing trade and investment. 43 Despite the higher cost of captive power (between 30 percent and 50 percent more expensive than power from PLN), many industrialists in Sumatera have resorted to self-generation due to the erratic supply of electricity. This adversely impacts on their competitiveness and willingness to invest further in the area. 76

95 Box 10: Growth Triangle (Indonesia- Malaysia-Thailand): Major Constraints to Infrastructure Support and Connectivity of Sub-Regions A key thrust of the IMT-GT sub-region is to strengthen infrastructure linkages and connectivity through the IMT-GT Roadmap The priority areas in the infrastructure development identified in the IMT-GT Roadmap include: (i) improvement of cross-border infrastructure and transport service connections; (ii) facilitation of road transport in the IMT GT sub-region through mutual recognition of vehicle documentation; (iii) development of shipping services and facilities to support cross-border trade and investment activities; (iv) improvement and development of transport infrastructure in the North-South corridor in Sumatera to enhance economic linkages with Malaysia and Thailand of the IMT GT sub-region; (v) improvement and development of IMT GT air services and facilities; and (vi) development of strategy and program for IMT GT cooperation in energy. During the past 16 years, the progress on implementation of IMT-GT Initiative was significantly below expectation, specifically with regard to strengthening roads, railways, airports, ports and electricity infrastructure at the inter- and intra regional levels. The underlying impediments to slow progress are consistent with the findings of this infrastructure growth diagnostic study. These are: Weak Human and Institutional Capacity which is apparent from the disconnect between strategies, programs and projects. Too many flagship projects were identified without considering the implementation capacity of the three governments, particularly at the local level. Furthermore, limited analytical work (prefeasibility and feasibility studies) was undertaken to guide project formulation. The weakness in human and institutional capacity is also evident in project information gaps and inadequate project monitoring systems. The success of development corridors such as the IMT-GT hinges on private sector participation. However, the paucity of bankable projects prepared by the government resulted in minimal participation by the private sector, and domestic and international financial institutions. Coordination Failures: Weak coordination at all tiers of governments (national, provincial and local governments) also contributed to slow implementation of the IMT-GT Roadmap. In particular, there was minimal ownership at the local government level since they were not actively engaged in project preparation and identification. In addition, there was also weak interface between public and private sectors. Lack of Financing: The implementation of the IMT-GT Roadmap requires $15-20 billion over a 10-year period, which is not a substantial amount of money for the three fast growing economies (i.e., compared to Indonesia s $200 billion mediumterm infrastructure plan). Under the IMT-GT Initiative, no proper financial plan was prepared and all the three governments were not providing sufficient funding for the projects. This is indicative of a lack of political will from all the three governments. Achievement of the objectives of IMT-GT Roadmap, in particular reducing regional disparities, is not possible in the remaining two years. A detailed diagnostic study encompassing all three countries to identify the binding constraints to the successful roll-out of the IMT-GT is warranted. Unless such an exercise is carried out, and a strategy to relax the most binding constraints is developed and implemented, progress on the IMT-GT will not be forthcoming to the detriment of both growth and equity. 77

96 where privately-owned land was earmarked for infrastructure development, and they were followed by speculative activity (i.e., there was a leakage in the information leading to land being traded prior to it being officially earmarked for specific infrastructure projects). This led to increase in land prices to levels much higher than the estimated price in the project plan. Although there is legislation in place to address the above speculative activity, it is not adequately enforced. In addition, as previously noted, there is no strong will on the government s part to enforce the law, which can facilitate rapid resolution of disputes over land prices. This is due to the fact that addressing the problem may be viewed as authoritarian and not pro-poor and, hence is unpopular. Moreover, during discussions with the private sector, it emerged that some of the land speculators were related to the bureaucracy, partly explaining why there was lack of appetite to address the issue. Government lacks the appetite to take decisions, which may be viewed as authoritarian. In an effort to avoid being seen as authoritarian, the government appears reluctant to get involved in land acquisition, and leaves the responsibility to the private sector participating in the project. Hence, the onus is on the investor to resolve the issue of compensation with the landowner. In several instances, where land is required for infrastructure projects, landowners inflate prices significantly. Sixty-five percent of 196 land acquisition problems that occurred since 1970 were related to conflict over compensation. Despite the availability of the regulations (Box 11), the government is extremely reluctant to acquire land through domain-type legal proceedings. Presidential Regulation 65/2006 and other regulations limit the legal options available to property owners to challenge government efforts to acquire land for infrastructure projects. Still, the government is reluctant to use the regulation, apparently concerned that it would be politically unpopular. To tackle this challenge, it recently established a revolving land acquisition fund managed by the Ministry of Public Works. The fund could play an important role in breaking the current deadlock over land acquisition for toll roads and other infrastructure projects. This is an important consideration for landintensive toll road development. Potential investors have long sought such a revolving fund to finance land acquisition to limit or remove this risk for investors. It may be noted that in general this acquisition risk, which currently rests with the investor, should ideally be addressed by the government prior to the investment decision, or be borne by the government. Inefficiencies in spatial planning compound the problem of land acquisition. At the regional government/provincial levels, rules and regulations in determining areas for housing, infrastructure and industry have not been 78

97 Box 11: Weak Formulation and Implementation of Land Acquisition Regulations Presidential Decree No. 55/1993 on Land Acquisition for the Development of the Public Interest specifies grievance procedures for landowners; defines public interest for development purposes; separates private projects, which should use regular land purchase arrangements; places more emphasis on community consultation and reaching agreement with people affected on the form and the amount of compensation; and presents expanded options for compensation including cash, substitute land, formal land title, and resettlement. This Decree laid down the rules on how the government could exercise the State s inherent power of eminent domain. Presidential Decrees No. 36/2005 on Provision of Land for Realizing the Development for Public Interests amended the earlier Presidential Decree No. 55/1993 and provided various forms of compensation for private assets needed to pursue government development projects. This Decree became controversial since the power of eminent domain was being used to profit private entities and received a lot of criticism from the public. Presidential Decree No. 65/2006 on The Procurement of Land for Realising Development for Public Interest was issued in June 2006 to amend the previous regulation on land acquisition (36/2005), correcting it by restricting the use of eminent domain for government development projects only. The legislation aims at shortening the land acquisition process and capping land costs. It provides the legal basis for the government to acquire infrastructure project land from the landowners by providing compensation in the form of money, substitute land and/or resettlement or other forms of compensation agreed by the parties. By and large, however, both Presidential Decree No. 65/2006 and Presidential Decree No. 36/2005 are similar, merely introducing refinements in the provisions of Presidential Decree No. 55/1993.The government has been extremely reluctant to acquire land through these eminent domain-type legal proceedings. BPN Regulation No. 3/2007 on Land Acquisition Implementation Guideline of Presidential Decrees No. 36/2005 and 65/2006. The Regulation of the State Minister of Agrarian Affairs and National Land Agency No. 1 of 1994 on Operational Directives of the Decree 55/93 was the enabling regulation in the implementation of Presidential Decree 55/1993. This enabling regulation was replaced by the BPN Regulation No. 3/2007. The BPN, an independent agency under the President, is the central government unit empowered to acquire land for public purpose. Presidential Regulation 13/2010 on Financing under Public Private Partnership Scheme would be able to deal with the land-related issues. Early this year, the government issued this Regulation, which affirms that there will be no PPP projects offered without ensuring the required land. Non-Supportive Regulations There are a number of other laws related to land acquisition, particularly the Basic Agricultural Law (1960) and the Forestry Law (41/1999) are non-supportive to each other. Under the Forestry law, the Ministry of Forestry has the power to acquire land for public purpose, but only forestry area, Local governments are only allowed to acquire up to 2 hectares of land for public purpose. Under Land Expropriation Act No. 20/1961 issued under Basic Agrarian Act 1960, if there is no agreement with the landowners, the state is entitled to take land by force, provided the land is required for the public interest. However, the expropriation must only be used as a last resort. These laws are not so well-defined that often causes disputes with BPN. 79

98 finalized. This process requires coordination at the central level among the relevant institutions, since spatial planning cannot be made by a single ministry, such as the Ministry of Public Works. In addition, there is a need for greater coordination between central and local governments on delegation of authority in order to avoid complications at the implementation stage. The lack of clear rules and regulations related to spatial planning has resulted in slow progress on infrastructure development in most provinces. ii) Weak Human and Institutional Capacity Dissolution of power through decentralization and a lack of coordination have resulted in inefficient decision making. Indonesia currently faces a problem with the level of fragmentation and dissolution of power between various government authorities. This has led to inefficiency in decision making due mainly to lack of clarity on roles and delegation of authority/ responsibility. The plethora of institutions and authorities has raised the issue of effective and efficient coordination among institutions dealing specifically with infrastructure development. Policy-making, decision-taking, implementing, monitoring and evaluation require considerable coordination among government agencies, not only at the central level but also at the regional/provincial levels, especially in the current era of decentralization where local governments play a greater role than before. This coordination issue has become more problematic after decentralization launched in Uncertainty over which level of the government is responsible for provision of services still exists, due to unclear assignments of various functions. In some cases, local/regional government s regulations are not consistent with that of existing national level. The lack of coordination within the government has also caused difficulties in dealing with it due to blurring of responsibilities, lack of accountability and ownership, and no clear delegation of authority. This has made it a frustrating and time-consuming exercise for the private sector in their interactions with the government (Box 12). Government lacks capacity to implement short- to medium-term plans. The capacity constraint within the government is apparent on examining its performance on the budgets. For example, a total of Rp 12.2 trillion was allocated for infrastructure in 2009, out of which Rp 6.6 trillion was for roads. During the first half of 2009, only 5 percent of that allocation was spent at the central and regional government levels 44. In addition, only 33 percent of central governments investment budget for 2009 was disbursed in the first 44 Standard Chartered Bank, Special Report Indonesia, 02 September

99 Box 12: Co-ordination Failures within the Government Adversely Impacts on Infrastructure Investment Even in instances where investments have taken place (despite the paucity of bankable projects and problems with land acquisition), the lack of communication and coordination within government resulted in project viabilities being compromised. This has further reduced business confidence in government s ability, and made investors wary of undertaking infrastructure projects. The lack of a holistic planning environment wherein long-term strategic inter-regional development plans are conceived, results in incomplete networks and lower than expected demand. The point is best illustrated by the two toll-road projects: Surabaya-Gempol Toll-Road (completed in 1986) and Waru-Juanda Toll Road (completed in 2008). Waru Juanda Toll Road The Waru Juanda toll road is part of the whole Surabaya Eastern Ring Road Toll Project (which commenced in 1997). Based on a potential daily traffic of 53,000 vehicles per day, PT Citra Margatama Surabaya (CMS), invested around Rp. 1.5 trillion by 2008 (twice the original value estimated in 2002). However, when the toll opened, actual traffic was only 23.6% of the estimated volumes, resulting in CMS experiencing substantial losses. This was attributed to poor networking of the Waru-Juanda toll road. The initial traffic projection of 53,000 vehicles is achievable if the road network around Waru- Juanda toll road is improved. In its feasibility study, the Waru-Juanda toll road would be integrated with both the East-ring toll road of Surabaya (Surabaya East Ring Road) and the Surabaya-Gempol toll-road. In the West, this Waru-Juanda toll-road will be connected with Surabaya-Mojokerto. In addition, the alternative road to Juanda Airport was upgraded and opened shortly before the toll road was completed, and captured a significant portion of the traffic that would otherwise have utilized the toll road, clearly reflecting coordination failures on the part of the government. Surabaya-Gempol Toll Road The Surabaya-Gempol connects Surabaya in the North and Gempol in the South of East Java, and is in operation since 1986 and was the main access road for Surabaya-Malang and Surabaya-Pasuruan (Pasuruan is one of the main industrial regions in East Java). The traffic volumes were much below the projected level due to improvements on alternate routes by the provincial government. This diverted potential traffic away from the Surabaya-Gempol toll-road, indicating weak coordination among various tiers of the governments. At all levels of government, planning and coordination of implementation poses even greater challenges since decentralization in The systemic nature of the coordination problem is also evident from the survey of key stakeholders, where 85 percent of respondents rated the quality of coordination within government as problematic (see section IV for a detailed analysis of the survey findings). In addition, coordination failures within government manifest itself as a constraint under the weak human and institutional capacity (identified as a binding constraint to infrastructure investment) of government (see section V) and government effectiveness lagging behind regional competitors (see sub-section iii below). Ultimately, coordination failures and an ad-hoc approach to infrastructure development have increased skepticism for PPP projects offered by the government, shaking investor confidence and thus adversely impacting on private infrastructure investment. This manifests itself in the low response rates on tenders issued by the government, and slow speed with which projects are taken up by the private sector. The government of Indonesia needs to adopt a holistic approach, specifically to infrastructure development to ensure synergies in the development process, effective and complete networks and efficient utilization of resources. 81